How to structure earnouts during startup acquisitions? An earnout is a risk-sharing mechanism for the acquirer in which the purchase price is reliant on the target company’s “future success.”
The acquirer pays a portion of the purchase price upfront when the deal is closed, and the rest is based on the target’s performance.
Suppose the seller believes the startup is worth $100 million, and the acquirer believes it is worth $80 million. In that case, they can agree on an $80 million initial price, and the additional $20 million can be earned and included in the earnout.
The $20 million might be based on:
- Earnings per share (EPS)
- EBITDA margins
- Key employee retention
- Achieving key milestones
Earnouts in a Merger and Acquisition Transaction
Disagreements about a startup’s valuation are nothing new in any transaction or business deal. The seller wants to achieve the best deal possible, and they may believe the startup is worth more than the acquirer believes or wants to pay.
On the other hand, the acquirer is concerned about the target startup’s ability to grow or retain key personnel or customers. Earnouts, which assist in bridging the gap between an optimistic seller and a hesitant buyer, is one possible answer to this challenge.
An essential part of the merger and acquisition process is understanding how to structure earnouts during startup acquisitions.
When is the Best Time to Use Earnouts
Earnouts are used in merger and acquisitions transactions to break purchase-price negotiation deadlocks. When the buyer and seller’s value judgments diverge outside the zone of potential agreement, an impasse occurs.
They’re also helpful as incentive and alignment tools to keep surviving management teams, and shareholders focused on the same goal.
Earnouts are also successful when a seller demands a high purchase price and the buyer wants to shift more of the performance risk associated with that price to the seller.
When Earnouts Become More Popular
- Financing: Higher market interest rates may be one of the motives why the acquirer chooses to make a deferred payment or pay with capital created over time from the acquired startup.
- Valuation gap: When the acquirer considers the target startup’s prognosis involves a hockey-stick valuation and is unreasonable, they will try to structure a lump sum payment ($80 million) and earnouts over the next 2-3 years for the remainder ($20 million – priced extra by the seller).
- Smooth Transition: The buyer prefers to defer some payments to ensure a smooth transition and get the target’s full cooperation in conducting business as efficiently as possible until the purchase is completed.
- Incentive-based compensation: If the acquirer believes it will take them 2-3 years to manage the startup without the target company’s current management, they will want to keep the management’s interest in the startup through earnouts.
- No delays = No regrets: Sellers can make the mistake of waiting to sell since they had tremendous development in a year. THough there is no telling what will happen tomorrow.
- Startups: Earnouts frequently get used for startups with less operating history but high growth potential.
When structuring an earnout, how the startup will function, who will have control over the organization, and other critical features are all factors to consider. What the startup achieves in terms of revenue, EBITDA, contributions from top customers, etc., is determined by a mix of these factors, which determines the seller’s payout.
How will the startup function? Who will have control over the organization? Who will oversee the day to day running of the business? These are some of the critical questions that you should consider when structuring an earnout.
The following should also be considered for structuring earnouts:
- Key executives: A startup won’t expand because of the efforts of a single person; it takes the combined efforts of the entire team. Therefore, it’s critical for the seller to include key executives in their strategy to help increase revenue and meet expected EBITDA margins.
- Contract length: The seller may not want to work longer under the new buyer’s restrictions and may wish to avoid future disagreements. With this in mind, it’s best to keep the contract length short and design the earnouts solely for that period. If everything goes well, the seller and buyer could always renew their contracts and modify their employment terms.
- Financial metrics: EBITDA, revenue, earnings per share (EPS), and net income are standard financial metrics. The seller prefers to base earnouts on top line revenue, which is harder to manipulate for the buyer but simple to achieve. It’s also possible that the business’s sellers will solely take on projects with poor margins to generate income. Buyers always seek to obtain a mix of revenue and margins for earnouts.
- Control: It’s unjust to reduce the seller’s earnings if a target isn’t fulfilled when he isn’t in charge of the startup. It’s essential for the buyer and seller to agree on a business plan and the level of control the seller will have after the acquisition to avoid this situation. The seller may want to be in charge of operations, marketing, and other areas where revenue and profits might be increased. It’s a good indicator if the acquirer maintains a respectful distance and appears to be relinquishing control, or is at least serious about empowering those targets to be hit.
Startups with solid growth potential, such as technology and service companies, are closely attributed to mergers and acquisition deals, with earnout clauses. For this reason, you should know how to structure earnouts during startup acquisitions.
Alejandro Cremades is a serial entrepreneur and the author of The Art of Startup Fundraising. With a foreword by ‘Shark Tank‘ star Barbara Corcoran, and published by John Wiley & Sons, the book was named one of the best books for entrepreneurs. The book offers a step-by-step guide to today‘s way of raising money for entrepreneurs. Most recently, Alejandro built and exited CoFoundersLab which is one of the largest communities of founders online. Prior to CoFoundersLab, Alejandro worked as a lawyer at King & Spalding where he was involved in one of the biggest investment arbitration cases in history ($113 billion at stake). Alejandro is an active speaker and has given guest lectures at the Wharton School of Business, Columbia Business School, and NYU Stern School of Business.