The Pros and Cons of earnouts in SF acquisitions

Earnouts are common in SME acquisitions, as they involve structuring part of the acquisition price contingent on the future performance of the acquired company. In most of the deals realized by searchers, earnouts have emerged as a strategic tool to bridge valuation gaps and align interests between buyers and sellers. Here are some of the advantages and disadvantages of incorporating them:

Advantages:

– Risk mitigation:

• For the Buyer: Earnouts mitigate financial risk by tying a portion of the purchase price to the company’s future performance. This structure ensures that the buyer doesn’t overpay for a business with uncertain prospects.
• For the Seller: Sellers confident in their company’s future performance can benefit from an earnout by potentially receiving a higher overall price if performance targets are met.

– Alignment of interests: continued collaboration & incentivization

Earnouts motivate sellers to stay engaged with the company post-acquisition to meet performance targets, ensuring a smoother transition and increasing the chances of success. By linking a premium to future outcomes, sellers are incentivized to work towards mutual goals, fostering effective cooperation and alignment of interests.

– Flexibility in valuation: facilitates agreement on price

Earnouts can help close deals where there are significant valuation discrepancies. It can bridge the gap between both parties, reaching a more agreeable and realistic valuation. If the seller believes the business is worth more due to future potential (or due to a bad last year performance), earnouts can provide a way to agree on a lower upfront price with additional compensation if future targets are met.

– Reduced initial capital outlay:

For search funds, earnouts allow them to lower their initial capital requirement, making it easier to finance the acquisition.

– Retaining key employees:

Even if it’s not usual in a SF deal, there have been cases where earnouts involve the seller (or key executives) staying with the company for a one-year period transition, which helps in retaining talent and ensuring a smooth transition and continuity.

Disadvantages:

– Complexity in structuring the agreement:

• Negotiation challenges: Crafting a fair and clear earnout agreement can be complex and time-consuming. Both parties need to agree on performance metrics, measurement methods, and payment conditions.
• Potential for disputes: Ambiguities in the earnout terms can lead to legal disputes and conflicts, undermining the transaction’s success (there has been an increase in legal conflicts in the past few years due to earnout calculation).

– Impact on management: short-term focus

Earnout structures can create tension and conflicts of interest between the seller and searcher, with the former prioritizing short-term performance over long-term health, potentially compromising the company’s future prospects and undermining new investments to grow. These differences in strategic direction and management style are intense if the seller remains involved post-acquisition as a shareholder.

– Risk of non-fulfillment:

• Uncertainty: There’s always the risk that performance targets won’t be met, resulting in the seller not receiving the full earnout. This can lead to dissatisfaction and morale issues.
• External factors: Market shifts and economic changes outside the company’s control can impact performance, affecting earnout payments and causing potential financial strain.

– Additional costs: monitoring and compliance

Tracking and verifying performance metrics for earnout purposes can incur additional administrative and audit costs, adding to the overall expense of the transaction.

Conclusion

Earnouts in SF acquisitions offer a blend of risk management, incentive alignment, and financial flexibility, making them a valuable tool for closing deals in uncertain environments. However, their successful implementation hinges on meticulous planning, clear communication, and robust agreement structures to avoid potential pitfalls. As with any financial instrument, the key lies in balancing the benefits against the complexities to achieve a mutually beneficial outcome for both buyers and sellers.