Contingent Consideration (Earnouts): A Good Approach to Make Deals

Earnouts are a smart way to make deals. They are beneficial to sellers as they get a payoff with the successful execution of the deal, while payouts work for buyers as an intelligent risk mitigation measure.Whether an investor is considering a merger or simply trying to get the best out of an investment in a venture, valuation is the key. It is critical for investors to make well-informed decisions and understand the risk involved. A fair valuation is a good indicator of future potential as well.

Ideally, records, audits, and account books should reveal the exact status of the business. However, it isn’t always possible to look at the black and white ledgers and get complete clarity. Businesses may not have proper records, there may be chances of falsification, or one might seek to invest in a new concept that still needs to prove itself.

While sellers often paint a rosy picture, investors tend to be cynical, and for a good reason. Without a clear valuation, more often than not, deals fall through.

A smart way to invest, or sell for that matter, is to create a contingent consideration. Also known as earnouts, contingent considerations require sellers to meet certain conditions within a specified time. Once the conditions are met, the acquirer fulfils their commitments for additional payouts as per the terms of the deal. This is ideal in cases wherein it is uncertain if a company or business will perform as per the owner’s vision. It helps a seller who is not completely convinced of the deal but isn’t ready to walk away either.

Eight Reasons Earnouts Make Sense

1. Pay for Performance – An investor could potentially reduce upfront investment, track KPIs, and make your investment decision based on first-hand account of performance.
2. Personal Goodwill vs Business Goodwill – Often, small businesses achieve success owing to goodwill. This could be due to their reputation as a brand or because of who is at the helm of the ship (owners or other key personnel). Contingent considerations allow buyers a buffer to understand if the business has inherent profitability or if it’s been running on goodwill. This further drives the need for the business to perform well.
3. Understanding of Longevity -Trends can be tricky. While some trends have a long shelf-life, others could disappear overnight. For some businesses, such as mobile/cell phone-related products, longevity is a question. This often leads to a disparity between what the seller wants and what the buyer is willing to put in. Agreeing to disagree on the valuation is the way to go. Transfer the difference to earnouts and allow the seller to prove that the business works.
4. Buy Time to Understand Viability - Market conditions seem to fluctuate as quickly as fads these days. While there may be potential in investing in an up-and-coming business, the time may not be right. A seller could wait for another similar company to come along. However, rather than lose out on a potentially rewarding business, it’s better to set a contingent consideration, ensure the business actually performs, and then invest.
5. Performance-based Valuation - Acquiring businesses with a compound annu9al growth rate (CAGR) of over 40% requires significant investment. While the potential rewards can be alluring, the risks are high. Hypergrowth companies often come with high valuations, which any smart investor can tread carefully. While the opportunity is enticing, an investor should make intelligent decisions and ensure growth stays on track until the business becomes sustainable. Seal the deal by linking your investment over time to performance.
6. Understand Potential to Scale - Smart investors like to come in early and ensure a good chunk of the business is safely in their hands. Small, growing businesses are often dependent on a few major clients. They may have minimal customer churn rates, but in some cases, the business has nothing to hold it up if a couple of key customers find an alternative. This is especially the case in industries such as aviation and defence. Hence, it’s viable to link contingent considerations to factors such as longevity of contracts, expansion of contracts, and increase in customer base.
   
7. Allow Time to Test New Markets - Often the most tempting investments are the ones that explore new markets. While the confidence that they come with is good, they may not have the right strategy for a new geography. Therefore, it’s wise to set clearly targeted growth initiatives in earnout conditions. Deferred investment plans are a smart way to ensure operational work and revenue from the acquisition fund the purchase while mitigating investment risk. This gives sellers the investment they need to expand, and buyers gain confidence in the business over time.
   
8. Share the Risks - One key aspect of setting earnout clauses when making a deal is that buyers transfer some acquisition risks back to the seller.
   

Why Should Sellers Agree to Performance Conditions?

1. Ratchet Down – In many cases, contingent considerations allow sellers to hold on to a larger share in the long run. Provided they have met the criteria of the deal, buyers may opt to return some of their stake.
2. Fixed IRR – The seller commits to a fixed Internal Rate of Return (IRR) for investors, and any upside is distributed only to the seller shareholders after a fixed IRR is met.
3. Add up the Goodwill - Pessimistic investors may ask for contingent consideration. This allows sellers to showcase their capabilities, gain investors’ trust, and build the relationship, provided they meet the consideration criteria. 
4. Fair Pricing Contingent considerations allow sellers to prove their business works and get closer to their asking price instead of turning down a deal or settling for a price they are unhappy with.

What Are the Different Types of Contingent Considerations?

There are various types of earnout structures you may want to set. While most of them concern growth or returns, you may want to ensure the business is a sustainable investment. Earnouts allow you to bide your time and even make an early exit if things aren’t going the way you expected.

1. Business Performance – Around 62% to 70% of the acquisitions have earnout metrics linked to revenue and other financial metrics. These kinds of contingent considerations are directly linked to how well the business does financially. You will likely want to monitor the performance of revenue over the next year and ensure revenue is consistent before investing to further expand the business.
2. Profit-Linked – Investment in a business with a strong revenue stream but less margins may worry an investor. In this case, an earnout based on increasing the percentage of gross profit, EBITDA, or profit after tax can be set.
3. Actual Gains - If the payout is based on how well the business performs, the investor could use metrics such as Total Shareholder Return. This will reflect the actual gain from the acquisition. 
4. Long-term Metrics - For buyers venturing into new areas or when managing assets, it is smart to link contingent considerations to long-term metrics such as Total Expenses Ratios. This is ideal when there is some opacity at the costs involved in running the target.
5. Qualitative Considerations - Factors such as ensuring X number of new clients are onboarded within a set period or expansion into new markets can help mitigate acquisition risk. When expanding to a new location, it is ideal to get a certain amount of purchase orders or contracts.
6. Business Scalability - If the scalability of a business is unsure, it is ideal to use milestones such as increasing customer acquisition or opening new branches and operating them successfully.
7. Innovations - When dealing with new technology, medicine, etc., an investor must be cautious. Even an experienced or well-connected investor may not have the technical know-how to understand the associated risks. In such cases, the investor must set contingent considerations for payouts following regulatory body approval, patents, etc.
8. Purchase Price Adjustments - Such a consideration allows sellers to reduce the buyout price if performance isn’t met or enable buyers to get what they consider the right value if performance is met.

How Contingent Consideration Payments Are Done

A buyer may choose to make additional payments or complete the remaining requested investment. For example, if the seller asks for US$ 300 million, you may pay out US$ 150 million first and pay the remaining as milestones are achieved.

Occasionally, deals get deadlocked because a seller isn’t willing to part with enough equity to make the deal appealing to the buyer. In such cases, a contingent consideration can be negotiated to take on more equity if investor involvement meets the seller’s criteria. Inversely, sellers may want to take back some equity after a certain point or even buy it back.

When investing early in a business that is likely to need more investors to come on board, buyers may ask for buyer option contingencies to be set. Measures such as Restricted Stock Units (RSUs) allow stock options to be set aside for a party to optionally buy for a set period of time before they can be sold to anyone else or until conditions are met. Another often overlooked contingent consideration is an acquisition note. This guarantees investors will get their money or some portion of it back after a set period. This is ideal when investors aren’t willing to risk all their money in the acquisition and seek a safety net in the form of created liability.

Conclusion

Contingent considerations are often the best way to ensure a deal goes through. When a buyer and seller can’t seem to agree on the valuation of a business but there is clearly some potential, earnouts are the way to go. 

They allow sellers to prove their business and business model works and potentially get the number they are after. From the acquisition viewpoint, an investment is likely to be successful without increasing risk. 

Aranca has significant experience in earnout valuations for various financial reporting needs and has withstood the scrutiny of the Big 4 audit firms and SEC regularly. We also advise clients on pre-transaction structuring and negotiations.