Why Are Earnouts Increasing In Business Acquisition Deals?

The last few years have been mayhem. I do not need to go into the details of COVID, rising interest rates, the war in Ukraine, and I’m sure I’m missing a few others. I do, however, want to go into the details of how these and other events have added what is now a common component to business acquisitions at all levels.

The unpredictability of many businesses coming out of the last few years has skewered valuations. Multiples were at an all-time high, and now they are all over the place. Some businesses got decimated by COVID, while others rose meteorically. Interest rates have bogged down a lot of small business transactions and activity and what we are seeing now in the aftermath of some dust settling, are erratic earnings.

While some companies may have done extraordinarily well, they may have clients who did not, and went out of business. Similarly, consumer products companies, many of whom have seen 20 to 30 percent revenue declines post-COVID. While many were raving about the new normal and increased revenues and profits in 2021, the euphoria of the COVID bubble activity came crashing down in 2022.

Determine The Value With Facts Not Hype.

Unfortunately, many business buyers bought into the hype, overpaid, overleveraged, and now with increasing interest rates, it is double-whammy time. They are getting clobbered.

On the flip side, the buyers that have recognized the COVID bubble, or, in many cases, the COVID collapse, are faced with potential acquisitions where sellers have a completely delusional valuation expectation. This is not necessarily news; seller expectations can be off the charts regardless, but even more so now.

The business type itself can often determine the morning after impact of COVID. As such, modifications can be made to the impacted years and their role in the valuation. In many cases, it makes sense to completely disregard COVID activity and look at 2019 and 2022 financials as a more realistic basis.

Bridging The Gap Between Expectations and Reasonableness

Earnouts are an excellent vehicle to provide protection to the buyer and upside to the seller. If for example you are acquiring a business and the seller believes that the revenues and earnings should be based on one set of financials, while you have a significant shortfall in your calculation, it is time to table a mechanism that rewards the seller if they are right and simultaneously covers you if you are correct.

A key piece of an earnout is to keep the formula simple, and the mechanism for measuring it perfectly clear. For example, a buyer can guarantee a purchase price of a certain amount based upon the undisputable revenues and income. Should the revenues and or income hit a higher level in an agreed upon period post-closing, the seller earns the additional amount.

As mentioned, simplicity is key. A very clear formula of what is being measured and what is and is not included are paramount. Keep the mechanism simple and the calculation is easy. Complicate it or allow it to be manipulated and mayhem will prevail. Clearly, the buyer must prevented from adding expenses or playing with the financials in a way to lower the metrics and therefore not trigger the earnout.

In cases where the buyer is an institutional investor and the seller is retaining equity, one should not be worried as it will be laid out in a clear, professional, and measurable way. If a seller is worried about their future partner messing with the books, they have bigger problems on their hands.

Eliminate Any Arguments

Maintaining simplicity in the metrics and the formula for measurement is key, but what if there is a dispute? That’s the easy part. Not the fun part, but the easy part. Any dispute can be subject to bringing in a mutually agreed upon third party accounting firm and they can make the final ruling. The beauty of numbers is they do not lie. People lie, but not numbers.

If buyers and sellers use earnouts effectively, both sides can achieve exactly what they want in a deal and have ideal protection in place in the event they were either overzealous or caution in their valuation.