Earnouts: Part 2 - Mechanics

“Forget about the earnout, assume that you’ll never see a penny of that money”

He’d been around the block on many deals, and seen the earnouts go wrong more often than not.

You pop the champagne, anchored on the total price that you have sold the company for, and count on getting paid all of it... Then you end up with far less.

Why does that happen? The mechanics of earnouts are poorly understood, and sellers often agree to terms that stack the odds against them. This often becomes their biggest regret about selling their company.

In Part 1, we covered why and when they are used. Check that out here – Earnouts: Part 1 - Why and when?

And here in Part 2, we jump into the nuts and bolts: the details of how earnouts work and the mechanics you can expect.

Next in Part 3, we cover how earnouts are negotiated, and explore how you can get the best deal. Check that out here - Earnouts: Part 3 - Negotiation.

Finally in Part 4, we will uncover how they go wrong and how to avoid getting screwed.

As a reminder, an earnout is a structure used in M&A deals where some of the purchase price is held back, and only paid to the seller if the company hits targets after the deal. To get up to speed, you can head back to Part 1 to read more.

What are the components of an earnout?

There are a million ways to structure an earnout. It’s more of an art than a science, and there is no standard one-size-fits-all approach.

Each one is subtly different, adjusted to suit the needs of buyer and seller and the context of the deal.

But the key components are the same. These are:

• Value. The maximum payment under the earnout.
• Metrics. What you will measure to determine payment.
• Calculation. The targets you need to hit and how much you get paid for hitting them.
• Timing. When payments are made.

Let’s jump into these three factors in turn, and understand the key points for each.

Value

This is maximum amount you can get paid under the earnout, if all targets are met.

Most earnouts will have a maximum that can be paid out (called the cap), but not always.

👉 How will the value be expressed?

You will hear this number phrased in different ways, which can be confusing. Sometimes you will see the same offer written as:

• “total price of £[x], which x% paid upfront and up to the remaining [x]% paid under the earnout”
• “£[x] paid upfront and up another £[x] paid under the earnout”.

Make sure you understand whether the buyer is quoting the total price (upfront plus maximum earnout) or just the upfront component.

👉 What proportion of the total deal value might be in the earnout?

This depends from deal to deal, and there can be a massive range.

In the most common scenario, the maximum earnout payment is around 10% to 30% of the total purchase price.

At the low end, the maximum earnout payment can be just 5-10% of the total deal value. This is almost like an employee’s annual bonus — a nice to have, but not a deal breaker.

And at the high end, almost all of the value is in the earnout and the upfront payment is immaterial.

👉 Why is there so much variance?

As we saw in Part 1, when the business has uncertain future performance a buyer will push for a larger proportion of the deal value to be contingent on success.

That might be because you are a start up with a short track record, or because you’re in an industry with volatile cashflows (like pharma).

Also, a large earnout will be requested if selling management is key and the buyer wants to strongly tie them into the business.

Conversely if you have a long track record, stable numbers and growth forecasts are reasonable, the buyer might only need a small earnout (or none at all).

This also comes down to the negotiating power of the parties. If you have competing offers from multiple parties, you can drive down the earnout component.

👉 What if the buyer wants too much earnout - how can I push back?

That is a common problem. The buyer wants to have the best of both worlds — own the business today but only pay for it if it does well in the future.

We will dive into that in detail in Part 3.

Metrics

This is the performance metric (or metrics) which is tracked to determine earnout payments. This is the yardstick against which you will be measured.

These are usually financial metrics, most commonly EBITDA or revenue, but can be operational too (or a combination of all).

👉 What metric is most common?

The metric used will depend on your business and its status, the buyer’s reason for buying you and where they see risk.

Most buyers prefer EBITDA. That encourages the sellers to drive growth but to do so efficiently and profitably. And if the buyer is a large, mature company (and especially if its a public company) they are themselves measured on EBITDA so it makes sense to align your incentive with theirs.

Revenue is most appropriate when the company is loss-making, or will be fully integrated into the buyer so it’s difficult to measure the stand-alone profit. Free cashflow can also be used in some cases.

Operational metrics are helpful if success is contingent on a single future event, like a key regulatory approval (like FDA approval for a drug).

Sometimes you will settle on a combination. For example, the target is revenue-based but the payments are adjusted down if the EBITDA margin falls below a threshold. Or you get an additional 'bonus' payment for hitting a regulatory goal.

That detail comes in the target and the formula used to calculate payments.

👉 What is the best metric for me?

The best metric is the one you think you have the best chance of hitting!

So think about your forecasts, and consider where you see the most risk. If you’re concerned about you margins being compressed or costs rising, then revenue might be more favourable than EBITDA.

If you are worried about top-line growth slowing down, then an EBITDA metric means you can manage the cost base to hit the target even if revenue is behind plan.

👉 Can I argue for adjustments to the metric?

Yes you should.

There might be situations in your deal where you feel like you’re adding value that’s not captured in the agreed metrics. For example, you might be supporting other business units in the buyer’s group with sales and marketing, but those sales don’t hit your P&L. Or think about how revenue from co-selling will be reported and accrued to your P&L.

Your costs might increase once you become part of the buyer’s group. Your regulatory burden might increase, or they might require more detailed financial reporting.

In those cases, you should agree pro forma financials. That takes your P&L and makes agreed ‘adjustments’ up or down to account for these factors. These pro forma adjusted numbers are those used in the earnout calculation.

The negotiation on this can get seriously detailed – you might end up with a whole schedule in the sale contract that just handles these adjustments.

Calculation

Once you have agreed the value and the metrics that will be tracked, you then negotiate the targets you need to hit and the amount paid for hitting them.

👉 How might this work?

There are 100 ways to do this… no two earnout calculations are the same!

This can get very complex. Lawyers and advisors love to get fancy with ladders, cliffs, ratchets, caps, accelerators, levers…

If you have negotiated commissions for your sales team, the features are similar.

Here are some common structures and terms to give you an idea of what you can expect.

The first thing to consider is whether the payment will be variable, tiered or fixed.

Variable. The earnout payment scales up and down based on performance. This could be expressed simply as a multiple of the EBITDA or revenue over the period, or “£x for every £x of EBITDA generated”.

Tiered. You have a set of targets, with specific earnout payments assigned to each of them. This works similar to the variable calculation, as the better the performance the more you will be paid. This could be expressed as “£x if you hit £x EBITDA, and £y if hit £y EBITDA”.

Fixed. The payout is a fixed amount, which is only paid if the target is hit. The payment value doesn’t change, so it doesn’t matter if you far exceed the target or just scape it.

Variable or tiered are most common.

Then additional layers are added on to to adjust the formula further. There are many options here, but these are the most common:

• Cliff. The minimum performance that you need to hit before any earnout will be paid. Sometimes called a floor. This is used in variable calculations to protect the buyer, so they only pay out if you exceed a base level of performance.
• Cap. The maximum that will be paid. Also used in variable calculations. Some earnouts can be structured without a cap, so the seller has unlimited upside (a bit like a sales person with an uncapped commission plan).
• Ratchet. An adjustment to a variable calculation where the payout mechanism changes for different performance levels. This can be used as an ‘accelerator’ in to pay out at a higher rate as performance improves. For example, you might get 6x EBITDA up to a certain level, then 8x EBITDA if you hit a stretch goal.

Putting these together, you might end up with a simple earnout formula like this:

The earnout payment shall be calculated based on the company’s cumulative EBITDA in the two years after completion, as follows:

If the EBITDA is less than £2m, no payment
If the EBITDA is £2m-£3m, the payment shall be 1x the total EBITDA
If the EBITDA is £3m-£5m, the payment shall be 2x the total EBITDA
If the EBITDA is over £5m, the payment shall be 3x the total EBITDA
The maximum payment shall be £30m.

This is a variable payment, with both a cliff (no payment unless you hit £2m EBITDA), a cap (£30m max) and a ratchet (the multiple increases with performance).

This gives the buyer good downside protection – they pay nothing unless the EBITDA is at least £2m. And the ratchet gives the seller strong motivation to really strive for a great performance.

👉 How can you make sure you clearly understand the formula?

These calculations can get very complex. There may be good reasons for adding the complexity, but in general you want this to be as simple as possible and only add bells and whistles where it is truly needed.

As the complexity increases, so does the risk that you and the buyer get your wires crossed. That can lead to disastrous outcomes down the line when you get a very different cheque to what you were expecting!

The best way to do this is to write down a list of performance outcomes, and calculate how much you might get paid for each.

So in the example above, you could do the following calculations:

• EBITDA £1m, Payout £0.
• EBITDA £2m, Payout £2m.
• EBITDA £3m, Payout £6m.
• EBITDA £4m, Payout £8m.
• EBITDA £5m, Payout £10m.
• EBITDA £6m, Payout £18m.
• EBITDA £8m, Payout £24m.
• EBITDA £12m, Payout £30m.

You should then share this with the buyer and ask them to confirm that they agree with the calculations. You might also include these in the legal drafting.

Timing

Lastly, once you have agree the value, metrics and the calculation, the last piece in the puzzle is the timeline.

You need to agree two things:

1) How long the earnout period will be in total
2) Whether payments are made in instalments throughout, or just at the end

👉 How long should the earnout period be?

Earnout periods can range from six months to five years, but two or three years is most common.

This is affected by the same factors as the value of the payment.

If you have uncertain future performance and sellers are key to performance, the buyer will push for a longer earnout period. That gives them a longer period where you have to prove the value of the business, and a longer period before they have to pay you.

If your success is dependant on hitting longer-term strategic goals (like launching new products or entering new markets), the buyer will push for a longer period too.

👉 When will payments be made?

There are two general options: (1) multiple, staged measurements and payments, often annually or more often; or (2) a single measurement and bullet payment, typically at the end of the earnout period.

Obviously as a seller you want to push for the first option – so you avoid the risk of an 'all or nothing' earnout, and start getting paid sooner.

Next

If you've got this far, jump to the next piece in this series on Earnouts.

That's Part 3, where we cover how earnouts are negotiated, and explore how you can get the best deal. Check that out here - Earnouts: Part 3 - Negotiation.