Brian Tunis authored an article for the July 2021 issue of Mergers & Acquisitions magazine highlighting the increased use of earnouts by private equity firms when negotiating M&A transactions in light of valuation challenges brought on by the pandemic.
Because the pandemic dramatically altered key metrics that have an impact on businesses’ financial health, buyers and sellers are more likely to have disagreements about financial forecasts and business valuations when negotiating a deal. For example, a seller is likely to prefer 2019 financial measures in valuating their company to get a higher bid that doesn’t account for the negative effects of COVID-19. Meanwhile, a buyer will want to account for any lapses in the business in 2020 to both negotiate a lower purchase price and address vulnerabilities in the business revealed by the pandemic.
As a result of this conundrum, earnouts have emerged and evolved as a solution to help close the valuation gap. Data from the SRS Acquiom® Marketstandard database shows that earnouts were used more frequently in 2020 than 2019. It also revealed an adjustment in the typical structure of earnouts. While earnouts generally have post-closing periods ranging between one- to five-years, they have historically leaned towards the shorter end of the spectrum. In light of the pandemic, there has been an increase of the post-closing earnout period with more transactions including extended earnout periods such as 2 or 3 years following the closing of the transaction. This longer period offers the buyer a more accurate view into the company’s post-closing performance as they are further removed from the pandemic, and it allows the acquired company more time to reach performance thresholds.
Another evolution in the way earnouts are being structured following the pandemic is the size of the earnout payment compared to their overall transaction: the median earnout potential as a percentage of the closing pay has risen from 18% in 2019 to 39% in 2020 according to SRS Acquiom’s® 2021 M&A Deal Terms Study.
Tunis suggests that private equity firms may be wise to continue using earnouts at an increased level for the near future to help drive transactions to close amid the skewed financial data following the pandemic, especially for smaller transactions where the financial impact may have disproportionately affected the target company.
Another advantage of the earnout is that it allows the parties to share the risk of sub-par future performance. “This strategy reduces the cash the PE firm needs to bring to the closing, which allows it to pay a portion of the purchase price with post-closing earnings (if any earnout payment is required at all,” Tunis said. “It also keeps the seller interested in the company’s future performance by tying a substantial portion of the purchase price to post-closing performance, which aids seller retention and helps prevent seller competition.”
For the full article, subscribers to Mergers & Acquisitions may click here.