In many middle-market M&A transactions, buyer and seller do not initially agree on the purchase price. One way to bridge this difference is to structure an earnout.

An earnout is a purchase price mechanism in which the buyer makes additional payments to the seller based upon the post-closing performance of the newly acquired business. Earnouts can be essential to completing M&A transactions when the buyer and seller have different views of value, particularly when part of that value depends on future performance.

For private company owners, especially in the lower middle market and middle market, earnouts are often used when a buyer recognizes the strength and potential of a business but wants part of the purchase price tied to results that have not yet occurred. This may arise when a business has strong growth prospects, new customer opportunities, recent investments, or projections that have not yet been fully reflected in historical financial results.

Earnouts are often designed to help both parties move forward. The seller may receive additional consideration if the business achieves agreed-upon goals after closing, while the buyer reduces the risk of paying the full value upfront for performance that remains uncertain.

Advantages of Structuring an Earnout

There are several advantages to structuring an earnout. Earnouts can reduce negotiation time in cases where neither buyer nor seller can agree on a valuation. An earnout can help the selling party receive additional value for their business by having the buyer make specific payments, over time, based on the business achieving defined performance criteria.

Through the use of an earnout, the selling company may receive more money, or in some transactions additional shares or equity value, than it would have if the acquisition were structured as a one-time payment at closing. Buyers like the use of earnouts because it reduces the risk of overpaying for an investment that does not achieve its financial projections.

For this reason, earnouts are often used to move a transaction forward when the parties agree on the quality of the business but disagree on how much future performance should be paid for at closing.

For example, a founder-owned business services company may have $4 million of EBITDA and recently signed several new customer contracts expected to increase earnings over the next two years. The seller may believe those contracts justify a higher valuation today. The buyer, however, may prefer to pay for that growth only after the revenue is realized. In that case, the parties may structure part of the purchase price as an earnout tied to revenue or EBITDA targets.

Why Earnouts Are Relevant to Private Business Owners

Earnouts are particularly relevant in private company transactions because many lower-middle-market and middle-market businesses are founder-led, relationship-driven, and dependent on future growth assumptions. A seller may believe strongly in the company’s future, while a buyer may focus more heavily on historical EBITDA, customer concentration, margin trends, or other risks.

In these situations, an earnout can allow both parties to proceed with a transaction. The buyer pays a meaningful amount at closing, while the seller has the opportunity to receive additional value if the business performs as expected.

Earnouts may be based on revenue, EBITDA, gross profit, customer retention, new contract wins, or other agreed-upon milestones. The appropriate structure depends on the nature of the business, the buyer’s concerns, the seller’s role after closing, and the degree to which the seller can influence future performance.

For example, a middle-market manufacturing company may have recently invested in new equipment that increases production capacity, but the financial impact may not yet appear in trailing twelve-month EBITDA. A buyer may be unwilling to pay full value for the expected margin improvement at closing. An earnout tied to gross profit or EBITDA may allow the seller to participate in the upside if the investment produces the expected results.

Similarly, a healthcare services company with a strong pipeline of new client relationships may be attractive to strategic and financial buyers, but the buyer may want protection if those relationships do not convert into revenue. An earnout tied to client retention, new contract wins, or revenue growth may help align both parties.

Key Considerations When Negotiating an Earnout

Experienced M&A advisers can help structure and negotiate an earnout that will be acceptable to both buyer and seller. A well-structured earnout can be beneficial to all parties involved. The buyer feels confident it is not overpaying for the company because the seller has to achieve certain performance thresholds in order to receive additional payments. The seller is satisfied because additional consideration will be paid if the business achieves its forecasts.

However, private business owners should understand that the details of an earnout are very important. The parties should clearly define the performance targets, measurement period, accounting methodology, payment timing, reporting process, and dispute resolution procedures.

For example, a revenue-based earnout may be easier to measure, but it may not fully reflect profitability. An EBITDA-based earnout may better reflect business performance, but it can be affected by expenses, accounting treatment, integration decisions, or corporate overhead allocations.

The seller should also consider how much control or influence they will have after closing. Once the transaction is completed, the buyer may control staffing, pricing, sales strategy, marketing spend, capital investment, accounting policies, and other operational decisions. These decisions can affect whether the earnout is achieved.

For this reason, sellers should not focus only on the headline purchase price. They should evaluate how likely it is that the earnout will actually be paid and whether the structure gives them a fair opportunity to achieve the agreed-upon targets.

A $30 million purchase price with $8 million tied to an uncertain earnout may not be as attractive as a $27 million purchase price with more cash paid at closing. The true value of an offer depends not only on the total potential consideration, but also on the certainty, timing, and terms of payment.

The Seller’s Post-Closing Role

The earnout has the added benefit of demonstrating to the buyer that the seller believes in the forecasts and that the seller is willing to support the business after closing. In many transactions, the founder or seller of a company stays with the company during the earnout period to help ensure that the company will achieve the desired results.

This can be valuable for both parties. The buyer benefits from the seller’s knowledge, customer relationships, and operational experience. The seller benefits from having an opportunity to influence the company’s post-closing performance and potentially receive additional consideration.

At the same time, the seller’s post-closing role should be carefully documented. The parties should understand the seller’s responsibilities, authority, compensation, reporting relationship, and ability to influence the business during the earnout period.

For example, if a founder-owned distribution company depends heavily on long-standing customer relationships, the buyer may want the founder to remain involved for one or two years after closing. In that case, the earnout may be tied to customer retention or revenue from key accounts. The seller should understand what authority they will have to manage those relationships and what support the buyer will provide during the earnout period.

Conclusion

Earnouts can be an effective way to address purchase price differences in lower-middle-market and middle-market M&A transactions. They can help sellers receive additional value for future performance while helping buyers reduce the risk of overpaying at closing.

When properly structured, an earnout can help both parties reach a fair compromise on purchase price and move a transaction forward. However, earnouts should be negotiated carefully, with close attention to performance metrics, payment terms, operating control, reporting rights, and the seller’s post-closing role.

For private company owners considering a sale, an earnout should be evaluated not only by the potential dollar amount, but also by the certainty of payment and the practical ability to achieve the required targets.

Versailles Group helps private business owners evaluate transaction structures, negotiate key deal terms, and understand how buyers may view value, risk, and post-closing performance. If you are considering a sale or evaluating an acquisition proposal, a confidential conversation can help clarify your options before entering negotiations.

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One of the most challenging aspects in structuring an M&A transaction is not necessarily the determination of a purchase price, but rather how that purchase price is allocated between the assets being sold. The major conflict at the core of this issue is the existence of tax polarity between the buyer and the seller. Generally speaking, the seller of the business is trying to maximize after tax proceeds while the buyer is trying to minimize the consideration relative to the after tax cash flow of future operations. Given these concerns, sellers typically look to sell stock while buyers usually want to buy assets. (Many times buyers prefer asset purchases because, in most jurisdictions, it limits liability. In Brazil, for example, it does not limit liability.)

Section 1060 of the IRS tax code attempts to mitigate conflicts regarding the allocation of the purchase price to various assets. Under Section 1060, both the buyer and the seller of a business are required to use the residual method for purchase price allocation. This means that the purchase price is first allocated to assets to the extent of their fair market value and any excess will be allocated to goodwill and going concern value.

A purchase price allocation is important to include in a purchase contract between a buyer and a seller because it gives guidance as to the tax consequences of the transaction. An allocation acknowledged by the two parties will allow the buyer to determine the basis of depreciable and amortizable assets while the seller is able to compute the sales price of the individual assets in order to determine any recapture amounts. With an allocation in place, the seller is also able to determine capital gains and ordinary income from an asset sale.

Although coming to an agreement about purchase price allocation can be challenging, having a tax expert and an experienced investment bank negotiating between buyer and seller will help both parties reach agreement on an allocation that is beneficial or at least fair to both parties and that conforms to IRS standards.

When determining the value of a business, there are three basic approaches that can be used to determine the fair market value. These three approaches are the underlying asset approach, the market comparable approach, and the income approach.

The underlying asset approach is a technique in which the assets of the business determine how much it is worth. The assets being valued are both tangible and intangible which means they are considered in the valuation regardless of whether or not they show up on the balance sheet. The final value of the business is determined by a simple formula: Assets – Liabilities = Value of the Business.

Another common method of valuing a firm is the market comparable approach. This is where one compares a business to publicly held firms whose stock is trading. A value is derived by examining the public firm’s EV/EBITDA or EV/Revenue multiples and applying a similar multiple to the non-public, target firm. (EV = Enterprise Value and EBITDA = Earnings Before Interest Taxes, Depreciation and Amortization)

The third way of valuing a company is the income approach. The income approach is based on the company’s potential earnings in the future. The most common way of doing this is by using the discounted cash flow method. The discounted cash flow method (DCF) is where one projects the cash flows that the business will generate and then discount these returns to their present value.

No matter which approach is used, the accuracy of the valuation will depend on the level of detail and depth of analysis that is used in deriving that valuation. It is important to ensure the accuracy of all inputs used in these valuation approaches as these inputs will ultimately impact the value calculation of the target company.

One final note on valuations; “paper” valuations are interesting and useful, but they may or may not be an indication of what a willing buyer may pay a willing seller. Versailles Group has sold a number of businesses for more than any “paper” valuation would have indicated. The key to achieving such a valuation is to have the right buyers and a strong auction.

M&A deal activity is continuing at a rapid pace. Global volume this year has already exceeded US$3 trillion and will likely surpass last year’s record volume.

One particularly bright spot for M&A activity has been Europe. For the first time in recent history, European M&A has expanded dramatically. For the first three quarters of 2014, this has meant nearly US$800 billion of transaction volume. By comparison, for the same time period last year, there was less than US$500 billion of transaction volume in Europe.

What is Due Diligence?

A question sellers often have is what is due diligence? Due diligence is the process that takes place after a letter of intent (LOI) is signed, but before the closing of the deal. It is a detailed investigation into the potential investment in order to verify the assets and liabilities and to make sure that the buyer understands what it is acquiring. Normally, it entails a complete review of the business, products, customers, facilities, background checks on the management, technological reviews, etc.

If the due diligence process is not comprehensive, then the buyer runs the risk of serious financial losses. It is imperative for the buyer to understand how the business operates and the potential risks before closing the deal no matter how big or small that acquisition may be. Due diligence is a way to ensure that neither party involved in the transaction was misled so the deal can be closed successfully.

Three major areas of financial due diligence

Most often the three most important areas of the financial diligence are; (i) the quality and accuracy of the financial statements and related information, (ii) the sustainability of the cash flows, and (iii) a thorough understanding of the tax issues that may arise due to a possible change of ownership. Prior to a sale, owners can significantly improve the value of their business by focusing on these three areas to make sure there are no issues.

Most buyers prefer audited financial statements; however, in the middle-market, a majority of the companies do not have audited statements, primarily due to the high cost. If a seller does not have audited financial statements, the most important thing is to have accurate financial data that is prepared in accordance with GAAP. Sloppy or inaccurate accounting data always makes buyers nervous about the value of the assets and the possibility that liabilities are under-reported.

The sustainability of the seller’s cash flows is very important to potential buyers as this information provides excellent visibility into the possible future performance of the target company. Buyers also like to know which products and services generate the highest margins and have the greatest growth potential in order to better recognize how they can integrate these products and services into their strategic plans and current product offerings. Buyers tend to pay higher multiples when there is a strong, diversified customer base from which they can grow the company.

It’s important that a seller understand that if the diligence doesn’t go well, the buyer may elect not to close the transaction or may ask for a price reduction. For that reason, sellers should make sure that their accounting records are up to date and accurate. Furthermore, to the extent possible, sellers should think about the most important parts of their business and make sure that they are ready to withstand the scrutiny of someone else’s due diligence.