Anyone who has been involved in M&A deals in the recruitment industry is almost certain to have encountered earnouts*. They are a well-established element of deal structuring and should not be regarded by vendors as a last resort, only to be considered if they have failed to reach an acceptable price for an outright sale. 

It has been said that owners should only sell their business if they are happy with the amount of cash they receive on the day the deal completes, but a well structured earnout can be an integral part of a deal and should not be discounted. 

Why are earnouts used?

• If the buyer and seller don’t agree on valuation of the business or forecast performance, an earnout may be structured to close the valuation gap, offering the seller the chance to prove that the business can deliver certain results

• They enable to buyer to manage risk

• Either party may not want an outright acquisition/sale

For the buyer

• Ensures the ongoing interest of the sellers in the performance of the business

• Reduces the risk of buying ‘thin air’

• Continuity of management may assist client transition and retention

For the seller

• Opportunity to increase price over an outright sale

• Can participate in and contribute to future growth of the business

• Opportunity to secure a deal now ahead of the pack waiting for an uplift in valuation

Beware

• Manipulation of results to skew the earnout (eg. management charges from buyer to depress profits, seller cutting costs to increase profits)

• Short-term vs medium-term decisions conflicting (eg. buyer wanting to recruit new staff, seller objecting as cost will reduce profits for the earnout and the benefit will come afterwards)

• Arguments over control and decision-making. This must be addressed in the contract governing the acquisitions

• Structuring incorrectly for beneficial tax treatment

A well-structured earnout should be rewarding for both the buyer and seller, so that they are both hoping the earnout payment will be maximised. This might sound unrealistic but it is absolutely true. If the acquired business sees an increase in profitability meaning that the buyer pays more to the seller during the earnout, a correctly structured deal will ensure that the buyer has bought the business on better overall terms, even though the absolute price has increased. 

The seller needs to ensure they are suitably protected during an earnout, which any good lawyer and corporate financier can advise on. There are well-established principles and mechanisms, which have been negotiated many times over and address key areas of risk.

In conclusion, buyers should seriously consider using an earnout as part of their deal structuring to protect their investment, while sellers should be open to accepting an earnout as part of a deal, ensuring that it is structured in a way to give them enhanced value for their business. There are undoubtedly tales of failed earnouts (just as there have been failed acquisitions) but equally there are many successful earnouts, which have worked well for both buyer and seller.

* A contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals.

For previous City comments, click here.