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“The earn-out won’t come anyway”- that is one of those sentences that M&A consultants hear a thousand times and yet they are always immediately startled. Why? Because it means trouble. If the founder himself does not believe in his own business plan, how is the buyer supposed to? Recent surveys by the investment bank Carlsquare from more than 250 transactions between 2010 and today have shown that in the vast majority of cases, 82.1 percent of the earn-out is actually achieved if it has been agreed upon beforehand. On average, 89.2 percent of the initial payment was paid out as performance-based compensation, and even the median is still at 50 percent – a quite lucrative business for all parties involved.
So why are so many founders sceptical about the earn-out?
Although currently, during the crisis, the instruments of the earn-out alone make transactions possible in the first place – sale slumps and associated uncertainties regarding company valuation can be bridged well by an earn-out – quite a few founders still have doubts about this construct. The reason: sometimes the scepticism lies not in the lack of belief in the company’s goals, but in the fact that it is difficult to leave the fate of one’s own company in the hands of others. What if the new shareholder on board pursued other interests than those of actually making the purchased company even more successful? Perhaps he simply intended to keep unwelcome competitors quiet? What if he imposed unnecessary costs on him, thus limiting his success? What if he lost control of his house. What if that ruined the results?
Detect rotten eggs
There are quite effective solutions to these concerns. For example, through contractually agreed earn-out protection mechanisms. This refers in particular to veto rights of the minority shareholder for unbudgeted expenses, which can be used to prevent arbitrary additional costs that could jeopardise the earn-out. Furthermore, founders should refrain from buying prospective buyers who do not promise synergies or even expect negative effects on the business, for example due to channel conflicts. In addition, founders should obtain earn-out references from past business partners of the buyer.
The current crisis gives earn-out much more weight than it already has. This is because the seller does not want to sell on the basis of this year’s poor figures, while for the investor the results from 2019 only have historical value. The earn-out offers the opportunity to circumvent the risks and negative effects of the current situation and to make the deal possible despite a drop in sales.
Which maturities generate the most profitable earn-out?
If buyer and seller are in agreement in principle, the question arises as to what period of time the earn-out should be agreed upon at best. Our evaluations have shown that on average a period of 1.5 years is set. According to our figures, one-year earn-outs lead to a 30-50% higher initial payment compared to earn-outs lasting several years. However, after one year it reaches on average only a comparatively low 27% of the original price. All in all, the earn-out after one year is still a fairly safe bank.
Deals with two-year earn-outs were the weakest in the overall result. With a three-year term, sellers were able to get more out in year two and three in particular (59% vs. 35% earnout in total).
With a term of four years, there have been repeated cases, especially in recent years and in transactions in the “Consumer Internet” segment, in which the founders were even able to increase the initial purchase price tranche 3.5-fold.
Put/Call or earn-out?
This question can be answered, as the business economist says, decisively with: “That depends! An option can be structured very differently. As a rule, a multiple is agreed upon, to which the corresponding option can be drawn. This applies to both the buyer (call) and the seller (put). This is then multiplied, for example, by the last realised EBITDA. This is how the value of the option is calculated.
Earnouts are occasionally provided with progressive scales, through which it can be advantageous for the seller to “beat” the business plan. For the “sportsmen” among the founders, the earn-out solution can therefore be more attractive because there is a potentially greater chance of achieving a higher purchase price if it is not capped.
Factors why the earn-out is not achieved
With seven out of ten cases, the most common reason why the earn-out was not achieved is a clear business plan failure. In second place, in one out of five cases, the missed target was caused by the withdrawal of an important customer. Even if the M&A advisor takes a lot of pressure off the entrepreneur, 3 out of 20 companies justify the earn-out loss by citing an excessively resource-intensive M&A process, which caused too much damage to new business. Finally, one in 20 sellers lost the earn-out due to incorrect accounting and subsequent adjustments required by the auditors.
If there are justified doubts about the objectives, then either earn-out clauses should be waived or the initial price should be negotiated high enough so that the earn-out, should it come against all expectations, would only be a nice extra income instead of a calculated share of the purchase price.
What must be avoided at all costs in earn-out agreements
While not all of the above factors can be excluded, there are certain clauses that must be avoided at all costs in order to achieve the earn-out. These include objectives that management cannot influence itself, for example, achieving technological milestones in which the buyer must play a significant role. Rigid hurdles, where even a single euro of sales below target prevents the entire earn-out, should be replaced by much fairer, linearly scaled distributions.
Finally, founders should make sure to incorporate a right to push the earn-out. In the event of an unforeseeable recession such as the current Corona crisis, founders are then able to postpone the earn-out. Ultimately, a smart and healthy sale is all about creating a win-win situation for all partners. If the parties involved do not work together, if they do not have the same goal, the transaction will be a failure for both sides. One better be safe than sorry when selling a company. Perfect foresight is half the battle and timing is everything.