The turbulent economic environment resulting from the COVID-19 pandemic has affected the M&A world in numerous ways. Among them is the increased focus on earnout provisions, both those in place from legacy deals and those being considered for inclusion in an upcoming transaction. This post provides an overview of the earnout mechanism and describes the alternative approaches dealmakers have at their disposal.
The purpose of an earnout is to allocate risk and reward between a purchaser and a seller in respect of the post-closing success of the acquired business. Earnouts are useful as a means of bridging the valuation gap: parties in disagreement over the future earning prospects of a business may be content to wait for a ‘final’ valuation once the success (or failure) of the deal over time becomes apparent. A ‘classic earnout’ refers to a post-closing increase in the acquisition purchase price. This increase is typically ‘earned’ if an acquired business’s performance exceeds a performance benchmark, most commonly EBITDA, gross revenue, or some other (often industry-specific) performance indicator. Alternatively, parties may use a ‘reverse earnout’, which results in a decrease in the purchase price if the performance of the target falls short of the chosen performance metric. In general purchasers will prefer an earnout, which implies a smaller payment due at closing, while sellers prefer a reverse earnout.
The form of the earnout is negotiated based on the relative bargaining power of the parties as well as the role- and impact- that the seller will have in the business post-closing. Common approaches to earnout provisions include:
- Metric used to calculate earnout: Common options include EBITDA, Gross Revenue, Regulatory Approvals (more common in healthcare or pharmaceutical deals), and Net Production (more common in industrial, mining or energy deals);
- Time period for calculating the earnout: 12-36 months is standard as discussed in the 2018 Canadian Private Target Mergers and Acquisitions Deal Points Study (Canadian Deal Points Study).
- Covenant for the buyer to run the business in specified manner: Common options include running the business to maximize the earnout, and running the business consistent with past practice (which is the most common according to the Canadian Deal Points Study).
The frequency of earnout usage has a nexus with the macroeconomic context within which the deal occurs. According to the Canadian Deal Point study, 16% of Canadian private M&A deals surveyed contained an earnout provision, which is less than in the US, where about 27% of surveyed deals in a comparable period contained an earnout provision, as discussed in the 2019 Private Target Mergers and Acquisitions Deal Points Study (US Deal Points Study). Note that the economic period in which these transactions were negotiated was relatively prosperous and stable. By comparison, 38% of deals in the 2010 US Deal Points Study contained an earnout provision, while in Canada in 2012- 2013 (a period of depressed natural resource prices and sluggish economic growth) earnouts featured in 25% of deals according to the Canadian Deal Points Study. The increased frequency of earnouts during uncertain economic periods reflects their utility as a means of allocating risk- particularly macroeconomic risk that is outside of the control of either party. Given the current pandemic and associated macroeconomic uncertainty, we expect to see renewed usage of the earnout mechanism.
If the earnout date is approaching in respect of an existing agreement, the implications of the pandemic could be quite severe from a seller’s perspective, as there may be a risk that the acquired business will not sustain whatever metrics would have generated additional funds. In order to minimize these consequences, a seller should closely analyze the definition of the performance metric chosen to measure the earnout. If the metric is EBITDA, there are often a list of inclusions or exclusions, including, in some cases, expenses that can be characterized as “extraordinary, unusual or non recurring charges” that can be carved out to lessen the impact of revenue loss. The seller may even be able to negotiate with a purchaser to defer the earnout calculation or modify it to mitigate the impact of the pandemic, provided that the seller has a motive for engaging in such negotiations.
An event like the pandemic certainly highlights the utility, and potential risks, of earnout provisions in M&A. Please contact a member of NRF’s deal team if you are dealing with earnout-related complexities or have further questions.
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