Despite practical challenges, earnouts are a tool that PE buyers should increasingly consider to reconcile differences and get deals done.
The use of earnouts, though historically disliked by PE buyers, is increasing across Europe. Earnouts can provide a way to bridge valuation gaps, a common need given frothy valuations pre-COVID-19, and a more frequently encountered issue during H1 2020. According to the forthcoming seventh edition of the Latham & Watkins Private Equity Market Study that examined deals signed or closed between July 2018 and June 2020, 18% of deals featured an earnout, compared to 16% and 14% in the 2018 and 2019 editions respectively. While the use of earnouts has challenges for PE dealmakers, earnouts have enabled parties to reconcile differences and get deals done, making them a tool that PE buyers may become more willing to accommodate in the year ahead, particularly given the uncertainties for many businesses caused by COVID-19.
Local Factors Influence Uptake
A tailored approach to use is required. Earnouts are more common in sales by non-PE sellers with the effect that markets mainly driven by primary deals — particularly Germany and Italy where family or smaller businesses turn to private equity to facilitate succession or to build growth — have seen a higher prevalence of earnouts. In continental Europe, 23% of deals featured an earnout in 2020, compared with just 7% of deals in the UK. Earnouts are also more common in the US, with 27% of US acquisitions by listed companies in 2018/2019 including an earnout, according to the 2019 American Bar Association M&A Deal Points Study, but remain rare in Asia.
Proceed With Caution
Common wisdom holds that an earnout is a failed negotiation. While this remains true for some deals, recent transactions have demonstrated constructive use of earnouts, particularly in sectors that require significant upfront investment and feature a lag in returns (e.g., pharmaceuticals), and in businesses acquired from individuals and founders. As the M&A market emerges into a (hopefully) reviving economy, but one in which inconsistent financial results will often feature in target businesses, earnouts may provide a mechanism to unlock the gap between parties.
That said, parties should proceed with caution. Earnouts are frequently the most heavily and lengthily negotiated term of deal documentation, and, in our experience, also one of the most frequently disputed. For PE buyers, consequent cash-financing needs (i.e., equity, debt, or cash-flow) and covenants regarding ongoing business operations can also be problematic. Further, many of the challenges that made valuation tricky during the deal negotiation period are likely to remain during the earnout period, meaning that careful specification of financial performance metrics is essential.
If an earnout is included, consider:
- How any payout will be financed
- Involving accountants at all stages of negotiation
- Ensuring measurement by reference to prior results, e.g., audited or diligenced management accounts
- Implementing specific accounting policies for subjective areas that may be open to interpretation or manipulation, such as how extraordinary items or post-completion operational changes should be treated
- Calculating a pro-forma earnout schedule
- Agreeing an appropriate period over which an earnout will be measured and payable— sufficient to realising the expected results, whilst not unduly fettering new business plan implementation. One to two years is often agreed as a reasonable length of time