3 best practices for buying or selling a business with earnouts during times of uncertainty

3 best practices for buying or selling a business with earnouts during times of uncertainty

With business uncertainty comes extraordinary challenges in using traditional models to arrive at a reliable company valuation. Can future earnings be accurately forecasted? Will a valuation in current circumstances create winners and losers in a transaction? This blog post  takes a look at the use of earnouts and the best practices to consider when buying or selling a business. 

Multipliers (i.e. valuing a company at a multiple of EBITDA, revenues or some other measure of business performance) are less appealing than in the past as revenue remains uncertain and industry comparisons may no longer be relevant. And shares-for-shares transactions, while appealing in certain contexts, may be difficult to justify under historically volatile market conditions.

Adjusting for the difficulties

One way that deal parties may seek to pave over differences in buyer and seller valuation expectations is to include earnout clauses in their deals. Earnouts are nothing new. They’ve been used as a tool to bridge valuation expectations, add an element of variable pricing or defer payments for decades.

Earnouts have been especially common in prior acquisitions of life science companies whose value often depends on the successful approval and launch of an experimental product. Despite the risk of frequent post-closing disputes regarding their achievement and calculation, we are seeing earnouts increase dramatically with the heightened challenges around predictability of future revenues and the resulting valuations in today’s environment.


What to consider?

Based on the analysis of the most relevant opinions in the industry,  here's three key tips to consider when dealing with earnouts in M&A during the current crisis:

  1. Avoid any potential conflict of interest by ensuring that continuing employees responsible for pursuing earnout goals are not also acting as shareholder representative. Such an arrangement may put an employee shareholder representative and the buyer in an untenable conflict that is unlikely to end well; the risk is even higher considering the lack of stability characterised by the unprecedented times in which companies are operating.

  2. Take into account that some level of conflict is likely even under the best laid out structures, and parties should be clear-eyed about how disputes will be resolved and who will resolve them. Keeping a part of the earnout funds in a segregated escrow account can provide an enhanced level of certainty in achieving milestones and unlocking further funds.  Funds held can provide a cash-based certainty in a period characterised by liquidity uncertainty. 

    A solution such as Shieldpay's can play a vital role in earnout disputes of all shapes and sizes, including disputes regarding the application of Commercially Reasonable Efforts, GAAP guidance, the meaning of contractually defined financial terms, and many others.

  3. Flexibility is key, earnouts tend to fall into two types: milestone-based achievements and  financial results, either of which can be limited to specific periods. If the parties’ ultimate goal is to ensure that buyers receive a fair price for the current business, but sellers receive some upside benefit of growth, a long-term approach is recommended to provide fairness and avoid painful conflicts. Valuable options are open-ended clauses or has an extended timeframe. For example, a financial milestone with a time horizon of several years may be appealing to parties who are optimistic about the business but uncertain about near-term performance.

-------------------

As you consider your next transaction and whether an escrow may help securing your earnouts, please feel free to contact us with questions.  Book a meeting with a Shieldpay expert here.

SHARE THIS STORY | |
   

Want regular updates straight to your inbox?

Recent Posts