Earn-outs are incredibly popular in sale/purchase transactions, particularly in IP- and principal-reliant business models (e.g. recruitment, marketing/communications, PR, management consulting). The primary objective of the earn-out is risk mitigation, in which the vendor of the business is required to remain involved for an extended period of time to ensure that the value is retained. The payment structure involves a series of deferred payments that are normally performance-based, and total consideration is generally capped. Private equity tends to utilise earn-outs as a way to bridge the gap between the vendor’s expectations and the PE buyer’s valuation of the business.
However, earn-outs are not a perfect model. The underlying structure of an earn-out is that the purchaser owns 100% of the business and therefore in a legal sense has complete control. The vendor, however, requires control of the business during the earn-out to ensure that performance targets can be hit.
Other negative aspects include the fact that material changes cannot generally be made to the business during the earn-out period by the buyer without triggering the full earn-out payment. Similarly, the earn-out is open to abuse by both parties, in that the vendor can drive down costs to maximise EBIT, and the buyer can potentially increase operating costs to decrease the effective EBIT. More cynical purchasers also attempt to fund the entire acquisition through proceeds from the business during the earn-out, leaving the vendor with little acquisition premium (and in many cases worse off than if they had simply retained the business for the same duration).
There is an alternative, which is in many ways superior to the earn-out. We call it a staged buy-out.
In a staged buy-out, the parties agree on a time period (like an earn-out) and the underlying valuation of the business. The purchaser then purchases a certain percentage of the equity in either the existing entity (OldCo) if the risk profile is appropriate, or the NewCo into which OldCo’s assets are transferred at Settlement. The vendor(s) receives cash up front, and in the latter case, shares in NewCo.
Put options are put in place to cover the sale of the vendor’s remaining shareholdings to the purchaser. This may be split into a number of tranches, each of which vests at a specific time (e.g. 12 months from Settlement, 24 months from Settlement, etc.). These options give the vendor the right – but not the obligation – to sell that portion of their shareholding at that time. The equity is valued using the same formula as that utilised at the beginning of the transaction (generally a goodwill + NTA formula). Call options may also be in place so that the purchaser has the right to purchase these same shares upon vesting.
Unlike in an earn-out structure, the vendors retain a seat on the Board and are not beholden to a set sell-out timetable. Once the options vest they can be exercised, but the vendor may choose not to and opt to remain with the business instead. Likewise, the purchaser may choose not to exercise their Call Option should the relationship be working well and the vendor’s continued involvement is desired.
Interestingly, one of the most important characteristics of the staged buy-out is that material changes can be made to the business at any time, as long as such changes are agreed to within the parameters set out in the Shareholder Agreement. For example, for major expenditure or re-branding of the business, 100% of the votes may be required. This protects the interests of both parties without being undermined by the level of voting control ascribed to either as the shareholdings change over time.
The staged buy-out is much more congenial arrangement than an earn-out, as both parties are committed to working together for mutual benefit. As the vendors maintain an equitable interest in the company, the level of commitment and care is naturally significantly heightened compare with an earn-out structure.
In the case of the earn-out, it is often a one-sided and antagonistic relationship that ensues: the purchaser after all owns 100% of the business and the vendor is instantly put in a subordinate role. Trust issues can come into play fairly quickly and transparency (or a lack thereof) becomes a concern for the vendor.
In so many ways, the staged buy-out is a superior transaction model to an earn-out. I have found some purchasers reluctant to consider it, but generally the response from both vendor and buyer is positive, as it is easy it see how risks can be mitigated and value enhanced for both parties under this structure. It should definitely be worth a look when considering your next transaction.
Andrew Cassin is an Exit Advisor and Business Broker licensed in Queensland, New South Wales and Victoria. His company, Acquisiti is premium business brokerage and advisory firm, providing services aimed at maximising the exit result for its clients. Andrew holds a Bachelor of Business and has pursued post-graduate studies in financial services, corporate governance, mergers & acquisitions, and change management. For more information contact Andrew via email at firstname.lastname@example.org