The negative financial impact of the Covid-19 pandemic has reduced the sale of businesses at a fixed price due in part to reduced revenues. Consequently, there is a price gap between optimistic sellers who believe the economic recovery is imminent and more pessimistic buyers. So, a business sale incorporating an earnout formula is a practical way to bridge that price gap.
In simple terms, the buyer and seller set a minimum selling price to be potentially increased by a formula based on future performance (contingent consideration). It is a win-win proposition because the seller will receive what they perceive as the fair value after meeting the performance metrics. The buyer, despite the additional consideration paid, will receive a viable business. Conversely, the seller must reluctantly accept the lower selling price as the business’s true value if they don’t meet the performance objectives. Because there is no one-size-fits-all business sale, earnout formulas are varied, complex, and often custom-designed depending on the type of business and the parties’ objectives.
A successfully executed earnout bodes well for both the seller and the buyer. This is particularly true when the future success of the business requires the continued expertise of the seller. The savvy seller motivated by the prospect of contingent consideration is incentivized to remain active in the business post-sale. Thus, achieving financial milestones rewards both the seller with the desired selling price and the buyer with a lucrative business.
The Complexity of Earnout Design
The easily understood benefits of an earnout belie their complexities. For estate and income tax purposes, the value of a business is of paramount importance. Since not all businesses are the same, it is important to design the appropriate structure to ensure a proper valuation.
One complicating valuation factor is the different types of seller compensation and an evaluation of the relative amounts of each type of compensation. Typically, the two types of earnout compensation are a right to fixed payments (guaranteed) and contingent payments (subject to achieving financial milestones).
Correctly choosing the underlying earnout metrics is critical because they dictate the earnout payoff risk. The greater the risk of a financial contingency not materializing, the greater the valuation discount. Importantly, analysts assess diversifiable and non-diversifiable risks associated with financial milestones differently.
Financial milestones are non-diversifiable and include target amounts of gross revenue or gross sales (usually favored by the seller), gross margins, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), net income or net profits (usually preferred by the buyer), and a number of units sold and occupancy rate (applicable to hospitality or real estate businesses).
On the other hand, non-financial milestones are diversifiable. They include regulatory approval (such as FDA drug approval), contract execution, customer retention, future transaction closing, and technical milestones (such as product launch, product development, software integration, and finishing a construction project).
Another complexity of the earnout structure relevant to payoff is the presence of multiple underlying metrics. An analyst must consider each metric’s forecast and risk characteristic and the correlation among the metrics.
How payments are made is also a relevant factor to valuation. A simple payoff structure is usually linear and can be based on a fixed percentage of underlying metrics such as EBITDA or revenue. On the other hand, a complex payoff structure is non-linear due to the underlying metrics. This type of payoff can have a minimum threshold, maximum cap, a tiered rate per unit of improved performance, or a carry-forward provision such as linking one period to another. The payoff structure affects risk, degree of leverage, and discount rate. Those characteristics, in turn, drive the valuation of the earnout payoff. In addition, path-dependent earnout milestones are also problematic in an analyst’s underlying valuation technique.
For example, subject to a cap of $20 million, the buyer of a paint manufacturer agrees to pay 50% of EBITDA over $50 million in Year 1 and 20% of EBITDA over $52 million in Year 2. This is a path-dependent earnout formula because whether or not the $20 million cap is achieved depends on the business’ performance in Year 1; and, if the cap is not reached in Year 1, it will be reached in Year 2.
As this example illustrates, path-dependency is the interrelationship of early-year contingent payments and subsequent-year payments. Thus, if there is an overall cap over a certain period with an early year contingency being more seller-friendly than a subsequent year contingency, it may be impossible to achieve the cap based on less seller favorable contingencies in subsequent years. Consequently, path-dependency and other earnout characteristics relevant to an analysts’ underlying valuation technique can be problematic.
Earnouts often contain various forms of settlements that can affect valuation. Each settlement type has its own risk and correlation with other metrics used in the payout structure. Although rare, there may be an open-ended payout structure allowing either party to choose a settlement type. For example, the purchase by a GM car dealership provides a payment of 5% of EBITDA in each of five consecutive years. Each year, the seller can opt out of the payout arrangement for a $500,000 payment.
Additionally, non-monetary considerations, such as the seller’s stock or the transfer of other assets, can further complicate the valuation. Whereas monetary consideration is definite, non-monetary consideration, such as the seller’s stock or other assets, may fluctuate in value—obviously affecting the value of the business to be either more or less than expected.
In this Covid-19 era, earnouts are more likely to be incorporated in the sale of the business. This article has described several aspects of earnouts that affect its valuation relevant for estate and income tax purposes. If you are going to use an earnout, you must plan it carefully to ensure that all parties can reap clear benefits from it. Due to earnout complexities, advisors should actively engage with clients early in the earnout design process.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Evan M. Levine is a chartered financial consultant at CompleteAdvisors in Valley Stream, N.Y. He has 30 years experience and has given dozens of educational seminars on retirement and estate planning.
Nainesh Shah is a chartered financial analyst and portfolio manager at CompleteAdvisors with 25 years experience. He is a member for the CFA Institute and has presented to numerous audiences of financial advisors and non-profits.
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