Next year is shaping up to be a very strong year for M&A activity in the Knowledge Economy. In order to assist your preparation for 2021, take a look at our M&A Preview, in which we discuss the following eight key trends:
- The adoption of digital is accelerating
- Emerging technologies are being commercialised rapidly
- There is a convergence across the sector and delivery models are blending
- Private equity participation in the knowledge economy is increasing
- Next-generation technology platforms are emerging
- Vertical software solutions are playing an increasing role
- Buyers are returning to nearshore locations for access to new skills
- Shareholders are aligning expectations and addressing structural risks
10 Critical Success Factors for Earn-outs
Earn-outs are a typical component of knowledge economy deals that are not one-size-fits-all and must be tailored for specific circumstances.
If you’re planning on selling your knowledge economy firm, it’s highly likely that the transaction structure will contain an earn-out. In fact, the vast majority of deals involving knowledge economy businesses will have a structure which includes some sort of deferred payment, with most taking the form of an earn-out. Your objectives would normally be to maximize the up-front cash percentage and alleviate the earn-out terms. Therefore, it is worth being aware of the complexities associated with earn-outs and having access to the knowledge which will allow you to structure it in the most sensible and beneficial way. Earn-outs can be used by a buyer for any number of reasons but some of the most common are:
- To obtain commitment from the vendors post transaction.
- To introduce specific targets which are non-financial to ensure a smooth transition post deal.
- To mitigate a valuation based on the delivery of a high growth forecast.
- To lower the day one funding requirement; and
- To bridge a gap in price expectations between vendor and buyer by allowing a higher headline value.
Earn-outs are not one-size-fits-all and must be tailored for specific circumstances. However, there are 10 over-arching considerations that should be considered.
1. What should the earn-out metric be?
There are broadly two types of earn-out:
- Performance-based earn-outs: payment of earn-out consideration is linked to performance against financial metrics, compared to pre-agreed targets. Metrics include the usual suspects - revenue, gross margin, EBITDA – but special attention is needed to precisely define how performance will be measured post-deal, given there is likely to be an increasing integration with the buyer’s business over time.
- Retention-based earn-outs: payment of earn-out consideration is linked to retention of key management (and sometimes to retention of the broader team). Typically, the intent of such earn-outs is to incentivize the management to support an agreed transition plan, but they are also used sometimes where the business is to be rapidly integrated into the buyer’s organization.
There is often temptation to agree a complex, many-variable structure to try and precisely align buyer and seller incentivization – but that should be avoided. Complexity of earn-out structure makes it difficult to negotiate and document legally during the transaction, and also difficult to measure post transaction.
Trying to make an earn-out achieve many different outcomes is fraught with difficulty. At its simplest, an earn-out should drive behavior which creates value and growth for the acquirer, while delivering full value to the sellers.
2. What should the earn-out target be?
Set it too high and it becomes a disincentive, too low and it won’t be incentive enough. The target should be achievable for the vendor and provide a mechanism which ensures good value, driving the right behaviors for the buyer.
It is difficult to provide qualitative advice on what a target should be, as clearly every situation will be different; however, you should consider the following:
- Base the earn-out on your existing organic business plan, as you should be able to deliver this as a standalone entity, and it should only be enhanced by the buyer’s infrastructure and client base – assuming minimal interference in the way you run the business.
- Whilst it is usual for a buyer to want to have a cap on the earn-out, it doesn’t normally make commercial sense for either party as the additional consideration from exceeding an earn-out can be self-funding. If you can, negotiate an earn-out structure that gives you upside potential from participation in the synergy case.
- Conversely, ensuring you include adequate downside protection within the earn-out is also key. This should ensure you still receive some value from it, even in the case of missing the headline target. However, for obvious reasons, this discussion needs to be handled carefully
- Avoid linking large proportions of the earn-out to specific targets with binary outcomes (a so-called ‘cliff-edge’ earn-out).
- Get a thorough understanding of what the combined business opportunity is and use this to assess the risk of missing earn-out targets, and the potential upside if you beat them.
3. What happens if you leave?
Ensure you know what happens to the earn-out payments if you have to leave part way through, either through your own choice or a forced exit. There are many ways to ensure that you are protected in this case. Often, the buyer will want to negotiate ‘good leaver’ and ‘bad leaver’ provisions which can be technically complex and are usually one of the most sensitive areas of the whole deal negotiation.
4. Consider the implications to the integration process
Performance-based earn-outs can sometimes be a hindrance to integration of the vendor’s business into the buyer as typically the vendor’s business needs to be ring-fenced from a reporting and operating standpoint in order for the earn-out to be measured. This can destroy value for the buyer and also undermine the rationale for undertaking the acquisition in the first place. If achieving the proposed synergies requires a high degree of integration, you may be better placed to focus the earn-out on retention or another non-financial basis.
5. Earn-out payments rely on the financial viability of the buyer
Being satisfied that the buyer will still be solvent at the end of the earn-out period, or including protections in the sales documentation, is key. In some cases, you may seek to carry out some level of reverse due diligence on the buyer (particularly important if some of the consideration is in the form of equity in the buyer’s group).
6. Set a realistic time period
By definition, an earn-out is at risk from the vagaries of market conditions, customer losses, technology advancement, increased competition, etc., and that risk increases the longer the period of time is. Conversely, the longer the earn-out period the larger the potential payouts. This would particularly be the case for an uncapped structure where you see strong synergy opportunity with the buyer (for example, if you have very strong IP deployed in a single geography which could be leveraged into global markets).
A two or three-year earn-out period is typical – obviously the shorter the better for a vendor. Our recent research highlighted that while the average length of earn-out was just less than three years, prolific buyers (those who bought more than two businesses per year) were more likely to prefer a shorter earn-out period. Knowledge of buyers’ behavior is invaluable in these negotiations.
7. Limit the basis of an earn-out to aspects of the business you can control post deal
For example, if your business is heavily reliant on marketing spend to achieve sales growth and post transaction you have no control of the marketing budget then immediately you are putting the achievement of your earn-out at increased and unnecessary risk. A full assessment of the transaction situation pre- and post-deal will highlight any areas of concern.
8. Corporate overheads
Be aware of any ‘costs’ which might be added to your P&L by a buyer post-transaction and which could limit your chance of achieving your targets. Knowing how a buyer will behave post-transaction and getting these issues on the table for discussion early is a key role for any advisor.
9. Tax treatment
With any performance-based payment there is a risk that the tax authority in your jurisdiction will look to treat it as income rather than capital. In most jurisdictions, that comes with a substantial increase in taxation rate. To achieve appropriate tax treatment, earn-out consideration needs to be clearly seen as deferred proceeds from the original sale. Get good tax advice early.
10. Details of the structuring
All or nothing earn-outs don’t tend to work, so typically a sliding scale with caps and collars to penalize underperformance and reward over performance are the norm. A thorough understanding of whether the buyer’s aims are purely financial or whether they are mostly strategic has an impact here.
Will it be possible to catch-up payments later? How is performance to be measured – quarterly, annually, on average?
Earn-outs can come in all shapes and sizes and the scope for getting it wrong is considerable, usually with significant consequences on what you expected to gain from the sale of your business. Understanding the motivations of a buyer and then formulating a structure which meets those expectations whilst protecting you as a vendor is the ideal scenario. A buyer will want an earn-out to be achievable and so will take guidance from the vendor and his advisor about how best to structure it as a win-win. We cannot outline every single earn out scenario in this article, but the real-world examples highlighted above demonstrate the value of drawing on the experience of an advisor like Equiteq to help you navigate this complex area.