The “Earnout” clause features in an increasing number of Australian M&A transactions – both public and private. This earnout requires the outgoing owner to “earn” some of the agreed sale value through achievement of certain performance level after acquisition.
WHY EARNOUTS?
When an acquirer assesses the value of a business they consciously or unconsciously estimate the size, timing and predictability of its future cash flows. But to protect against downside risk they attempt to negotiate that part of the purchase price should be deferred and dependent upon the post-acquisition performance of that business.
EXAMPLES
Of the 355 midmarket transactions that have occurred in Australia so far in 2016, nearly 11% had some form of earnout clause
Here are three Australian midmarket 2016 transactions
Simple Earnout ..
PSC revealed … that the initial payment for the purchase will be $2.02 million, with subsequent payments to be based around a rise and fall formula dependent on the income of the business over an 18-month period from the completion date.
(PSC / Hiscock Insurance Brokers)
More complex …
Montech is spending $9 million on Tetran ($4 million in cash and 142,857,143 in MOQ shares). The deal also entails a performance-based hurdle to enable the owners to earn up to a maximum of 28, 571, 429 shares ($1M in MOQ shares at $0.035 per share), scaled if FY16 EBITDA exceeds $1.65 million with the maximum $1M payable if Tetran exceeds $1.77M
(Montech / Tetran)
Or even more complex:
“The purchase price is NZ$9m, which may increase based on the performance of the merged entity over the 12 months following completion. The purchase price is subject to a potential performance payment, calculated as: $2 x the amount of recurrent revenue of the merged group (GeoOp and Interface IT) in excess of $4.5 million for the year ended 30 June 2017 Recurrent revenue represents gross recurring subscription and licence fee and support revenue received from ordinary customers”
(GeoOp / Interface IT)
EARNOUT COMPONENTS
Deconstructing these, and more than twenty other midmarket deals in 2016, we found several components
PROPORTION that the earnout represents of the total sale value.
Degree of CONTROL that the outgoing owner has in the performance of the merged entities performance.
TIME from completion of the sale to the receipt of the final payment by the outgoing owner.
UPSIDE v DOWNSIDE. Whether the outgoing owner have the opportunity to benefit from an upside that exceeds the original sale price by over performing the target.
INTEREST: Whether the owner receive any interest on the deferred payment.
SHARES vs CASH: whether is a predefined cash amount or an allocation of shares with as yet undetermined future value.
PERFORMANCE CRITERIA: Whether the performance goals should be measured on revenue, profit (which measurement?) or one of multiple other criteria: recurring revenues, customer acquisition / maintenance, sales of a specific product etc.
PRESENCE of OUTGOING OWNER: The need to determine the outgoing owners required involvement, and what contracts and financial payments should be included in the agreement.
AGREEMENT TO INVEST IN/ SUPPORT THE BUSINESS: How the strengths and synergies of the acquirer will assist in achieving the performance goals.
OPPORTUNITY TO MANIPULATE. The extent to which post acquisition performance can be skewed –through, potential downside practices such as asset stripping, forced termination of key employees and Capex burdens as well as unforeseen market, competitive or other extrinsic developments.
WHAT CAN GO WRONG?
No matter how tight the agreement, things can go wrong and when they do, disputes can create anything from focus distraction and financial stress to an emotional rollercoaster to the outgoing owner.
To minimise the possibility of these events, consideration should be given to:
· The need to maintain records that are consistent with past practice, apply the same accounting standards and thus provide a direct comparison.
· Consideration given to how circumstances could change if the acquirer were themselves acquired or acquire another business.
· The process and players who should be involved in the resolution of any disputes.
In conclusion, a growing proportion of midmarket M&A transactions will, in future, include some form of earnout clause inserted by the acquirer in order to offset a downside risk.
GREAT ADDITIONAL SOURCES
How to Structure your Earnout – John Warrillow
Owner Left ‘DEVASTATED’ by Business Sale – A Timely Reminder For Us All – Joanna Oakley
Structure Business Sale Transactions to Create Bonus Value for All – Tony Brown
Guide to Vendor Finance for Business Sales – Joe Kafrouni
Mark Ostryn is a director of Strategic Transactions advisory business and has provided financial and commercial advice for his M&A clients regarding deal structuring.
