By Jonas Schweigart
When a company is up for sale, buyers and sellers often have different ideas about the purchase price, which is usually due to an asymmetry of information between the two parties. On the seller’s side, this asymmetry can lead to an overestimation of opportunities and an underestimation of risks, resulting in inflated purchase price expectations. The buyer, on the other hand, tends to overestimate the risks and, in most cases, derives a potentially significantly lower purchase price from this. The resulting gap between the purchase price expectations of the parties involved is difficult to bridge and therefore leads to the premature termination of many transaction projects.
One of the most popular methods for successfully completing an M&A transaction despite differing purchase price expectations is the use of an earnout mechanism. This is a provision implemented in the company purchase agreement that divides the purchase price into a fixed portion to be paid at the time of closing and a variable portion (the earnout). The latter is paid at a later date and varies in amount depending on the performance of the target company. To this end, fixed targets are defined in the clause, which are then used to determine the actual earnout to be paid. The company’s performance is usually evaluated over a period of 2 to 3 years, on an annual basis and with the help of selected financial indicators. In European transactions, the net income or operating result is used in most cases (48.7%), followed by EBITDA (12.8%) and EBIT (5.4%).(1)
In turbulent times like today…
In practice, it can be observed that earnout clauses are increasingly used in transactions with a high degree of valuation uncertainty. This is the case, for example, in cross-border or cross-sector transactions where the purchasing company has less information about specific market conditions and there is therefore a high degree of information asymmetry. (2) By using earnout clauses, the buyer can mitigate the risk of an incorrect valuation.
Companies are currently facing a number of challenging developments that are greatly increasing economic volatility in almost all areas. The conflict in Ukraine is creating a climate of uncertainty across all industries and has also exacerbated existing supply chain difficulties. Added to this are record inflation and a persistent shortage of skilled workers in many industries. Together, these factors make corporate planning and valuation more difficult, further widening the gap between the purchase price expectations of the parties involved in M&A transactions. Earnout clauses are therefore becoming more important under the current economic conditions and offer opportunities to successfully complete transactions even in a difficult market environment. Both buyers and sellers should therefore consider the possibility of an earnout clause at an early stage and be aware of potential pitfalls.
Pros & Cons of the Earnout Clause
+ Bridging purchase price differences between buyer and seller
+ Incentive for the seller during the earn-out period
+ Reduction of the buyer’s economic risk
+ Reduction of the necessary transaction financing
– Transfer of economic risk to the seller
– Risk of the buyer influencing valuation-relevant key figures
– Potential for future conflict between seller and buyer
In order to use earnout clauses profitably for all parties, great importance should be attached to the choice of specific conditions. In particular, it is necessary to consider the period over which the company’s success is measured and which key figures are used. It is crucial to align the relevant conditions with the objectives of both parties in order to create the right incentives for achieving the transaction goals. In addition, a key performance indicator must be selected to measure the variable purchase price portion to be paid that does not offer any potential for manipulation by either the buyer or the seller. Otherwise, one of the parties could attempt to artificially reduce or increase the purchase price to be paid. Another key component of a successful earnout arrangement is a legally secure contractual structure. If this cannot be guaranteed, there is a high risk of subsequent legal disputes. In this case, an earnout clause would merely be a means of postponing today’s differences until the future, which could potentially involve high costs.
Conclusion
In summary, earnout clauses are an effective means of bringing transactions to a successful conclusion in the current climate. In order to make the most of the advantages offered by earnout clauses, buyers and sellers should therefore address the issue at an early stage and seek professional advice (legal and tax).
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(1) Ewelt-Knauer et al., 2011, in Schmalenbach’s Journal of Business Research
(2) Cain, Denis et al., 2011, in Journal of Accounting and Economics
