When you are going through an acquisition, and perhaps having a startup M&A advisor guiding you through the process, it is important to keep in mind that there are seven fundamental components to earnout structures:
- Total/headline purchase price
- Upfront payment
- Contingent payment
- Earnout period
- Performance metrics
- Measurement and payment methodology
- Target/threshold and contingent payment formula
These elements are better illustrated and comprehended in order, with each one building on the last.
1. Total or headline purchase price
The first step is to determine how much money the vendor will receive in total. Suppose the buyer is aware of the seller’s asking price and maintains a strong negotiation position. In this case, the buyer will almost always set the total purchase price at the same level as the seller’s asking price.
This informs the seller that the buyer is willing to cover the entire valuation gap, giving the seller a chance to get the purchase price they want.
2. Upfront Payment
The next step is to figure out what percentage of the total purchase price will be paid at closing. The maximum amount of the upfront payment should equal the buyer’s enterprise value (EV) calculation. It is a critical variable because it represents the buyer’s capital-at-risk—that is, the capital in the risk zone that will be written off if the target underperforms so dramatically that its EV is less than the upfront payment.
Buyers often desire to reduce the risk of a transaction by lowering the up-front payment below their calculated enterprise value, shrinking the risk zone.
3. Contingent Payment
The third step is to calculate the contingent payment, which is calculated by subtracting the purchase price from the upfront payment. This is a critical step when understanding how to structure earnouts during startup acquisitions.
4. Earnout Period
The fourth stage is to calculate how long it will take you to earn your money. Earnout periods usually last between one and five years, with three years being the average. The earnout period should be long enough for the surviving management team to fulfill its objectives, but not so long that “goal fatigue” sets in.
5. Performance Metrics
The fifth step is to choose the performance metric utilized to evaluate the target company’s performance above all others. These criteria should be mutually agreed upon, understood well, well stated, and easily quantifiable.
Financial and operational performance metrics are the two types of metrics.
- Financial metrics, such as revenues or EBITDA, are often dependent on revenue or profits. When the target firm is completely integrated into the buyer, revenue is often consumed, making it difficult to analyze the post-assimilation standalone profit profile. Profit-based measures such as EBITDA are employed when the target startup continues to function as a standalone subsidiary with its own set of distinct financials.
- Operational metrics are commonly measured using milestones and are most prevalent in technology and pharmaceutical companies where new product development can significantly boost the target firm’s EV.
6. Measurement/Payment Frequency and Methodology
The measurement and payment frequency are the sixth steps. There are two broad options in regards to this:
- multiple staged measures and payments carried out annually or more frequently
- a single measurement and bullet payout, usually towards the end of the earnout term
The various measurements/payments system is frequently advised against since it causes significant management stress, noise, and distraction. However, it’s usual for the seller to prefer smaller, more frequent milestones and payments to stage and limit the adverse effects on their operational risk.
The measurement methodology must be determined in addition to the frequency of payments. There are two general methodologies:
- a financial performance growth rate between the acquisition date and the earnout maturity date, such as revenue or EBITDA compounded annual growth rates (CAGR)
- an absolute value target, such as cumulative EBITDA, can be achieved between the acquisition date and the earnout maturity date.
7. Target Metric and Contingent Payment Formula
The seventh step is to identify the target measure (i.e., the performance level) and the payment amount associated with that degree of performance.
The structure should compensate the target startup for partial success to balance risk and reward, even if it does not accomplish its goals. In other words, a binary, all-or-nothing strategy rarely gets seen in or by the market.
In general, the buyers prepare and submit the financial accounts and other elements that determine the earnouts. On the other hand, the sellers are given full access to the documents and can contest the earnout calculations. Arbitration clauses, such as the appointment of an independent accountant or auditor, will be included in the definitive agreements to resolve any disputes in an effective and timely way.
If you’ve done your research on M&A transactions, you already know that the possibilities of your startup being effectively integrated or thriving as a separate business following a sale are low.
Unfortunately, certain acquirers use the opportunity to use earnouts to get your startup at a low price. They are not obligated to pay you if you fail to meet your milestones and targets. They may choose to make achieving them extremely tough for you.
Even if it isn’t on purpose, it will be more complicated than you believe or are accustomed to. You may be on a fantastic growth path right now. A merger, or the credibility of being associated with a more prominent firm, their resources, and access to more capital, may appear to be a quick and painless method to boost your startup on to the next level.
However, regardless of your new position, your ability to accomplish anything may be close to nothing as an employee. You possibly won’t obtain the funding or team you expected, and your new accountants will approach your books differently than you did as the founder.
If you’re trying to determine how acquisition earnouts operate, ensure you negotiate:
- Your budget
- Your new management team
- Performance is measured by top-line revenues or sales rather than profit.
- You have adequate money in the bank to legally fight back and defend your earnout
- Enough money upfront to be content even if you don’t get any earnout money
Earnouts may or may not be ‘standard’ in your industry, but you may and must negotiate the more delicate elements and put them in writing if you are serious about taking your startup to the next level and risking your funds.
When considering how earnouts in acquisitions function from the standpoint of a founder, there are clear advantages and disadvantages.
- A possibility to sell your startup for a much higher price
- With additional resources, there’s a better chance to prove value
- The prestige and respect that a larger exit brings
- There’s a good chance you’ll never see a cent of your earnout money
- The resolve to work as an employee for a long time
- Rather than moving on to your next endeavor, you’re stuck in limbo