In April 2017, we discussed 10 tips for structuring earn-outs. Since then, we have seen the continued use of earn-outs in private M&A transactions, particularly those involving UK targets.
1. Use for short-term incentivisation
There are two main reasons for the use of earn outs – to bridge valuation gaps (and those gaps, in our experience, are widening) but also, increasingly, to incentivise management sellers in the short to medium term.
Traditionally in management buyouts, management equity has served to incentivise management to drive growth and increase their gain on a future exit of the target business. An exit would typically be expected within 3-5 years of investment. However, many private equity houses are now raising longer life funds and are prepared to hold certain assets for between 7 and 10 years in order to maximise their investment return. As a result management equity may, in a private equity context, be perceived as being a longer-term and therefore less valuable incentive. Consequently we have seen earn-outs used as a more immediate means to motivate management sellers to deliver growth in the target business in the short to medium term.
2. How long must a seller wait?
Earn-out periods of between one and two years remain the most common, but we are also seeing some three year earn-out periods (with partial payment(s) at an earlier stage). Given the relatively strong negotiating position of sellers in the current market, sellers are generally able to resist earn-outs beyond this period (i.e. push for payment on a shorter timescale). We suspect this extension of earn-out periods is attributable to growing valuation and equity incentive gaps (see above), but do not expect to see further extensions any time soon. Sellers will be unwilling to wait much longer, and buyers may fear that a longer earn out period could complicate strategic or structural changes, such as the disposal of non-core assets within the target business or changes at management level.
3. Sector (and general) trends
Earn-outs can feature more prominently in certain sectors, such as life sciences where earn-out payments may be linked, for example, to a regulatory approval or product milestone (which can be used in place of or in addition to financial performance milestones). Similarly, earn-outs are often used in the acquisition of “people businesses” (for example, consultancies) or, more generally, businesses that are reliant on the management sellers to remain involved to drive future growth post-completion. We are seeing earn-outs used in almost every transaction in high-growth, competitive sectors such as software or tech-driven services.
4. Performance targets
The earn-outs we see are most commonly tied to financial targets, typically based on a sales or revenue target. Earn-outs are of course generally a buyer-favourable concept however targets based on revenue protect sellers by being more difficult for a buyer to manipulate post-completion. Conversely, buyers generally prefer an earnings based metric (such as EBITDA) as this will more likely tie in with their valuation of the business.
We have also seen earn outs being prepared on a sliding scale basis (as opposed to an earn-out payment based on a single performance target) to ensure there is some reward for the management sellers even if the best case performance is not achieved . Where an earn-out is not achieved in the first year, we have also seen many buyer also agree to a “true up” to allow a seller to catch up if there is sufficient outperformance of the business in a subsequent year.
5. Security for earn-out payments
Sellers will typically request some form of security from the buyer to ensure they receive payment if the earn-out requirements are achieved. Establishing an escrow account to hold an earn-out payment is one possibility, but in our experience it remains unattractive to buyers. Buyers often do not want their cash locked up for a defined period, or they may not be able (or want) to draw down the full amount of the purchase price at completion.
Trade buyers may provide a guarantee from a large trading group entity as security. However, this option will usually not be available to a private equity house, which would be unable to grant security over its other portfolio companies.
An alternative option we have seen with increasing frequency is to allow the management sellers’ restrictive covenants to lapse if the buyer defaults on an earn-out payment or breaches its earn-out covenants, potentially in combination with accelerated vesting of their management equity.
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