Like Rodney Dangerfield, Earnouts Just Don't Get Any Respect
Earnouts are hardly perfect, but they can be useful if they're understood by all parties.
Imagine that you're a psychologist for a second. Mr. Earnout walks into your clinic. You have been seeing Mr. Earnout for three years now. In fact, your clinic is booming with patients with the exact same malady as Mr. Earnout: A serious case of the Rodney Dangerfield blues.
"I just don't get any respect," he says.
Business brokers hate Mr. Earnout. Sellers don't have many nice things to say about him either. And buyers?
"Surely buyers must love you Mr. Earnout," you say. "Didn't buyers invent you as a way to make brokers' and sellers' lives miserable?"
"You see, that's the thing," Mr. Earnout says sadly. "Even buyers dislike me. Nobody likes me."
And yet, earnouts are still used in transactions all the time. So why does Mr. Earnout feel this way? Good question. Let's take a look behind the earnout's bad rap.
Understanding Mr. Earnout
Earnouts are used to bridge a valuation gap between a seller and buyer. This valuation gap isn't usually a result of what multiple is being used, but rather what the company's earnings should be. That's why earnouts are often used for high-growth companies.
Let's say that a company has an average TTM EBITDA of $5 million and the comparables indicate that a reasonable multiple should be 5X EBITDA. The company would, therefore, have an enterprise value based on historical EBITDA of $25 million. However, let's suppose that the company expects to hit its earnings out of the ball park in the coming year to the tune of $7 million in EBITDA, perhaps as a result of additional industry activity, a new technology or new products.
So here's the problem: The buyer feels the business is worth $25 million based on the proven $5 million EBITDA, while the seller knows the company will do $7 million and should be worth $35 million. That leaves a price gap of $10 million.
Enter Mr. Earnout, the ultimate mediator. In this case, an earnout could be negotiated such that the last $10 million of the purchase price is contingent on the seller achieving EBITDA above $5 million all the way to $7 million.
"Seems reasonable," Mr. Earnout thinks. "Everybody wins right?"
Not so fast.
Why Earnouts Make Sellers (and Their Advisors) Cringe
So what's the problem with this seemingly simple solution? Two words: Risk transfer.
When an earnout is in place, the onus is on the seller to deliver; the buyer refuses to "prepay" for performance that has not yet been delivered. The risk is squarely on the seller because a portion of the purchase price is contingent on actually meeting the projection. Buyers have a hard time believing a projection because most projections are just "unbelievable." They most often settle on paying for real performance. They'd rather compensate later if the future performance is achieved.
Now, in fairness to the seller, earnouts aren't usually seller friendly, especially if there really is a catalyst that is likely to drive performance higher. Earnouts are often structured on a one-for-one or two-for-one basis. This means that for every dollar above the EBITDA threshold, the purchase price gets increased by $1 or $2. This multiple may, therefore, not match with the multiple paid on the balance of the transaction.
There's also the time value of money to consider. Earnouts are paid out in the future and often don't earn interest (and they most certainly won't if sellers engage a poor investment banker who doesn't think about these finer details). They are riskier than consideration shares or seller financing in that they get paid in the future without the seller being compensated for the time or risk involved.
No wonder advisors cringe. They advise their sellers to avoid earnouts like the plague. Clearly, all the above noted reasons warrant this position. Plus, if you're a smart seller, you'll also tie the advisor's fee to the earnout component of the deal. That may not work out in the advisor's favor, either.
OK. So, clearly earnouts have their benefits — and problems. Can buyers pull them out like super-weapons to make a deal seamlessly come together? Well... not really.
Buyers Cringe, Too
The problem is that earnouts aren't really buyer friendly, either. At least, they aren't friendly to the right kind of buyer. That's the kind who will work with the seller to build a company, one that's more valuable than the sum of its parts. Earnouts get in the way of that.
Here's how: The example company above may be able to hit $7 million EBITDA, but it might take $2 million in capital investment to do it — more equipment, a new distribution center, additional facilities, additional working capital, etc. Now, just where do you think that capital is going to come from? The buyer. How should the earnout be modified to account for this capital investment? This is where it starts getting complicated, and how the risk often slowly transfers back to the buyer.
In the buy and build strategies often deployed by private equity firms, the highest levels of value creation happen when the use of resources (capital, human resources, infrastructure, distribution channels, facilities, ideas) is optimized. The problem is that earnouts discourage resource sharing. It may be that the only way our example company hits $7 million in EBITDA is if significant leverage is derived from the buyer's systems and processes. Should the buyer "charge" the seller for this? It's a recipe for disaster and what usually happens is that the buy and build strategy gets delayed until the earnout period expires. Result: The buyer loses more on reduced value creation, integration and general momentum than what it gains by having an earnout in place.
Plus, earnouts have implications for corporate culture. Because the seller has to remain somewhat isolated to allow it to achieve its earnout, cultural integration suffers. This is the No.1 reason why M&A transactions fall short of expectations, according to most studies.
The bottom line? Earnouts are hardly worth it for buyers most of the time.
So What's the Solution for Mr. Earnout?
Earnouts are hardly perfect, but they can be useful if they're understood by all parties. They have to be properly articulated with terms including not just the formula, but how resources will be shared and the impact of future capital investment on the formula itself. In other words, Mr. Earnout should just be himself.
When valuing companies, I prefer to incorporate the seller's performance risk into the multiple or discount rate used to value the company. Then, I estimate the company's recurring future cash flow, determine the level of risk associated with this cash flow estimate and adjust the discount rate accordingly, totally avoiding earnouts, if possible. Overall, I don't particularly like earnouts and seldom use them. Sorry, Mr. Earnout.
What do you think? Am I giving Mr. Earnout a fair shake? Let me know in the comments below.