When You Disagree on the Purchase Price

Understanding the Valuation Gap

The most common scenario for earnouts is when buyers and sellers can't agree on company value. This typically happens in several situations:

• Recent Performance Spikes: Imagine a company doubled its revenue during COVID due to unexpected market shifts. The seller believes this represents a permanent evolution in their business model, while the buyer sees it as a temporary surge. An earnout can bridge this gap by rewarding the seller if the performance proves sustainable.

• Future Revenue Catalysts: Consider a software company that just signed three major enterprise contracts set to begin next year. The seller wants full value now for these guaranteed contracts, while the buyer prefers to see successful implementation first. An earnout tied to successful contract execution satisfies both parties.

• Industry Transformation: In sectors undergoing rapid change, like healthcare tech or renewable energy, earnouts can help account for uncertain but promising future value creation. If the transformation succeeds, both parties win.

Beyond the Valuation Gap

While bridging valuation disagreements is the primary use case, earnouts serve several other purposes:

• Key Person Retention: When a company's value is tied to specific individuals, earnouts can ensure they stay engaged post-acquisition. This is particularly crucial in professional services firms or companies with strong founder-client relationships.

• Technology Completion: For companies developing breakthrough technologies, earnouts can be tied to development milestones, protecting the buyer while rewarding the seller for successful innovation.

• Market Expansion: When acquisition targets are poised to enter new markets, earnouts based on successful expansion can align incentives and reduce risk.

Lessons from Private Equity

Middle-market PE firms have mastered the art of earnouts, offering valuable lessons for smaller transactions:

• Keep Metrics Simple: PE firms typically focus on EBITDA or revenue targets, avoiding complex calculations that can lead to disputes.

• Use Clear Measurement Periods: Usually 2-3 years, with annual or semi-annual measurement points.

• Include Protection Mechanisms: Successful earnouts specify minimum investment requirements and operational autonomy to give sellers a fair shot at achieving targets.

Building Trust with Sellers

The biggest concern sellers have about earnouts is whether they'll get a fair chance to achieve the targets. Here's how to address this:

• Operational Autonomy: Clearly document the seller's continued authority over key decisions affecting earnout metrics.

• Independent Oversight: Establish third-party accounting review for performance calculations.

• Clear Communication: Regular updates and transparent reporting help maintain trust throughout the earnout period.

• Investment Protection: Document minimum marketing spend, R&D investments, or other resources necessary for success.

Implementation Best Practices

To maximize the chances of a successful earnout:

• Choose Appropriate Metrics: Revenue works well for high-growth companies, while EBITDA or SDE is better for stable businesses.

• Set Realistic Targets: Base thresholds on detailed financial modeling and market analysis.

• Document Everything: Specify calculation methods, including treatment of extraordinary items, acquisitions, or accounting changes.

• Plan for Disputes: Include detailed arbitration procedures and identify neutral experts in advance.

Common Pitfalls to Avoid

Many earnouts fail due to preventable mistakes:

• Overcomplicated Formulas: The more complex the calculations, the more likely disputes become.

• Unclear Definitions: Failing to specify how various business scenarios affect calculations.

• Poor Integration Planning: Not considering how post-merger integration might impact earnout achievement.

Conclusion

Earnouts remain a powerful tool for getting deals done in uncertain times. They work best when:

• There's a clear valuation gap based on identifiable factors

• The metrics are simple and measurable

• Both parties commit to transparent communication

• The seller maintains enough control to achieve targets

Remember, the goal isn't just to close the deal – it's to create a framework for successful integration and value creation in the future. When structured thoughtfully, earnouts align incentives and create win-win scenarios for both buyers and sellers.

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