First, Who Cares?
Earn-outs describe the conditions under which acquirers make additional payments to sellers after they reach certain performance goals post-close. So, earn-outs are a way for buyers to reduce the risk of overpaying for targets.
Conversely, earn-outs give sellers the chance to make more off the deal than buyers are otherwise willing to pay at close. In sum, earn-outs can close valuation gaps between buyers and sellers that might otherwise become deal killers.
In 2023, about a third of private tech M&A deals featured an earn-out, and that share has been trending up in concert with rising perceptions of political, economic, and technological risk.
So it pays sellers to acquaint themselves with the mechanics of purchase agreement earn-outs for two reasons: 1) They’re now rather commonplace; 2) As you will see, they usually work to the buyer’s benefit.
The good news is that there are a number of things sellers can do to mitigate buyers’ home-court earn-out advantage, important among them the services of a competent M&A advisor.
Your Handy Factoid Earnout Chart
To add some context to the above chart:
Today, earnouts average 15% to 20% of total deal value. That assumes full payout and, as we shall see, that’s a big assumption.
Seller revenue post-close drives two-thirds of earnouts. The remainder splits between EBITDA and A) other financial statement metrics; B) various operating milestones, e.g., R&D or client maintenance goals. Know that the further down the income statement an earnout driver lives, the more vulnerable it is to post-close operating changes and even to manipulation. Therefore, revenue is the least subject to goalpost moves, though it isn’t bulletproof.
While the average earnout period is two years, the range is broad — six months to five years. Whatever the duration, it’s typically limited by the seller’s willingness to stay on the job.
Shockingly, only 55% of sellers realize any earnout compensation. The culprits are often sellers’ overconfidence in future performance while caught up in the heady rush toward close, post-close disputes over ambiguous terms, and, as mentioned, buyers fiddling with overhead adjustments, withholding growth investment, etc. In fact, such buyer moves may not be deliberate. An example of unintentionally reducing sellers’ earn-out is when the buyer must increase corporate overhead across the board, with the knock-on effect of reducing the seller’s earn-out driver, EBITDA.
Of the 45% of sellers that receive earn-out compensation, only about half of them, or 25% of all earn-outs, deliver max payout.
Three Ways to Avoid Earnout Disappointment
First, familiarize yourself with common earn-out practices so you’re aware of terms that diverge from the norm. Re-read the chart above.
Second, learn about how to skirt the earn-out pitfalls that are nearly certain to sow disappointment. Accomplish this objective by visiting my article Understanding Earnouts: An Entrepreneur’s Guide.
Third, retain a competent M&A advisor. They not only guard sellers’ interests in earnout design and negotiation, but they also work to reduce the earn-out’s share of overall seller compensation, increasing cash at close. A particularly compelling way to do that is by injecting buyer competition into the M&A process.