Buying and selling a business: ‘Earnouts are the new reality’

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Many have heard of the contractual entity known as an earnout, but its complexity runs deep, meaning there are many ways for an earnout to go sideways, hurting both the buyer and the seller of a business.

Fundamentally, an earnout is used in a mergers and acquisitions (M&A) deal when the buyer and the seller of a business have different opinions regarding the company’s valuation, both at the time of the sale and its post-acquisition potential.

But their use in M&A contracts has skyrocketed in recent years thanks to significant ebbs and flows in the marketplace and the state of these kinds of deals.

According to the 2023 earnouts update from Harvard Law School Forum on Corporate Governance, while their use has not doubled as some reports have suggested, there has been a notable rise in their use.

The report states that, “Since the COVID-19 pandemic began in 2020, there has been a higher proportion of M&A deals including earnouts – used, as usual, to bridge gaps in buyers’ and sellers’ views of valuation in light of economic and financial uncertainties in the marketplace generally and with respect to specific businesses. Also, earnouts have been used in some deals this year to address difficulties in upfront financing as the M&A financing environment has remained challenging.”

A mechanism ‘to get deals done’

Mark Borkowski, president of Toronto-based Mercantile Mergers & Acquisitions Corp., explains that before the pandemic “earnouts weren’t discussed because people were paying with real money, with real dollars, with covenants and whatnot.”

He adds, “Everyone dropped off at COVID, but they still wanted to sell their businesses. They wanted to sell these companies because they were in their 80s or 70s. They said, ‘Look, I want 2019 value, my best year, but I realized that my ’21, ’22, ’23 numbers are lacking, but I want the numbers.’

“Earnouts are the new reality,” he says. “It’s a mechanism for us to get deals done.”

He adds that, while there are fewer M&A deals going on in today’s market, there is also a disconnect between what the seller still believes their business is worth and the current valuation, so earnouts allow buyers and sellers to share the risk.

“There’s a way to get there. Not easy. It’s not cash, but we can get there. We’re not talking about the low number we started with. It gets them over the gap.”

But Borkowski does warn off agreeing to an earnout that solely involves sharing the profit bottom line.

“We know the liability, we know what the downside to that is,” he explains. “The guy who bought the business can load the company up. He put his brother on it. He hired a new advertising agency. He bought a bunch of equipment. [Then says] ‘Hey, no profit. Sorry’.”

Setting a floor and a ceiling can mitigate risk for both parties, he notes. The seller wants to know they will at least get a basic amount, a floor. The buyer, if they intend to invest in increasing the business’s profits, do not want to pay for their own efforts, so impose a ceiling.

The main elements of an earnout are the financial goals that must be met (and how that’s measured), the time frame in which these goals need to be achieved, and who gets what compensations should these goals be met.

But within those areas, there are numerous paths to take.

‘What don’t we know?’

David Ford, a business and M&A lawyer at Vancouver-based Clark Wilson LLP, says one of the first things he tells clients to consider is why they even want an earnout built into their deals and questions if potential sellers need to be more certain about the valuation of their companies.

“The bottom line is that an earnout is really, in my mind, only appropriate when there’s a contingent element of the value, where you’re like, ‘I just don’t know if the value that you want, seller, or the price that you want, if the value of the business matches that,’” says Ford.

The questions, says Ford, come around the potential uncertainty or the contingent element of the earnout: Where are the questions or uncertainty about the value coming from? He says that if the seller knows their earnings and/or sales and potential from, say, a certain division, then that should all be part of the valuation, so is the seller being too lofty in their valuations?

“Discussions with my clients centre around questions like: ‘What don’t we know? Why are we pricing it this way?,’” says Ford. “From the buyer’s perspective, I don’t want to pay as much if I don’t know what’s going to earn out, so then what are we talking about? What is not currently functioning on full cylinders that we need time to figure out if it’s actually got the value that the seller thinks it has? It’s super tricky.”

Besides the cost of the earnout itself, should one be considered, those entering into these deals need to also consider the upfront costs of writing up the terms.

“I guarantee you that, transactionally, costs will go up trying to deal with this earnout,” adds Ford.

The contractual drafting for earnouts takes a lot of time and consideration because each one is unique and how an earnout is measured requires a lot of back and forth to work out.

‘Earnouts can get contentious’

Michelle Alphonso, partner, national lead for transaction advisory services and private equity at Grant Thorton LLP in Toronto, says that the success of an earnout comes from all the details considered to set it up.

“You want to create alignment between both parties,” says Alphonso. “Earnouts can get contentious … You see a lot of earnouts that result in unhappy parties on both sides of the table because of something like whether an earnout is based on revenue, gross margin, or EBITDA.”

For instance, earnouts deals that were structured in 2019, pre-pandemic, were likely not meeting their financial goals as the world economy took a nosedive. But how can the parties plan for this kind of uncertainty?

For this reason, Alphonso’s main advice is to get the right people around the table that have done this kind of M&A deal and contractual agreement before because, “there’s a lot of nuance with deal making that comes from experience.”

“And if you have an in-house team they should know when to bring in the experts to compliment the knowledge they have,” she adds.

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