Bridging the Gap More Efficiently through Equity-Like Earnouts
Earnouts secure additional payments post-acquisition based on performance, bridging gaps in buyer-seller perspectives.
Traditional earnouts face challenges with investment horizon misalignment; equity-like earnouts align incentives and timelines effectively.
Private equity transactions require careful consideration of tax implications and holistic valuation for equity-based earnouts in the company's capital structure.
An “earnout” functions as a contractual arrangement wherein the buyer agrees to make additional payments post-closing if the acquired business achieves specified performance targets or certain predetermined events occur. This mechanism proves valuable in situations where there are differing perspectives between the buyer and the seller regarding the anticipated future operational performance or the likelihood of specific contingencies. In cases where the seller will continue to play a role in the post-closing operation of the business, an earnout serves as a beneficial incentive for the seller to contribute to the growth of the business for the buyer’s advantage after the closing.
The Pitfalls of Traditional Earnouts
One challenge associated with earnouts is the discrepancy in investment horizons between private equity sponsors and the typical timeframes for earn-out payments. Private equity sponsors usually operate on a five to seven-year investment horizon, in contrast to the more conventional one to three years for earn-out payments. This discrepancy results in a midstream cash outflow from the Portfolio Company or sponsor, potentially causing a misalignment in the seller’s ultimate upside participation. Such misalignment may create incentives for the selling party to prioritize assisting the sponsor in realizing its return.
Potential Solution: Equity-Like Earnouts: Aligning Incentives and Timelines
To tackle these challenges, private equity sponsors are increasingly customizing the structures of earn-out payouts to harmonize with the performance of their equity investments. This ensures alignment in both timing and incentives for all involved parties.
From a sponsor’s perspective, equity-like earnouts are advantageous because they secure payouts only when the sponsor attains a targeted return on its invested capital. This distinction underscores the heightened alignment between equity-based earn-outs and the sponsor’s investment goals, given their close connection to the sponsor’s ultimate financial outcomes and the influence they wield over exit events.
Equity-like earnouts not only align the duration of the performance period with the investment horizon but also enable direct settlement from deal proceeds. This strategic move eliminates the need for sponsors to invest additional funds for the earnout during the middle of their investment horizons, addressing potential misalignments in upside participation.
Contrasting Traditional Earnouts with Equity-Like Earnouts
In a traditional earnout, a portion of the total consideration is contingent upon on how well that business performs in the future, often linked to specific financial goals. This ensures that the buyer and seller share a common interest, motivating the seller to contribute to the success of the business after the acquisition. For example, if a manufacturing company is acquired with a traditional earnout, the seller will receive additional payment if the company achieves certain revenue targets over the next few years.
On the flip side, an equity-like earnout gives the seller a stake in the acquiring company instead of additional cash. This ties the seller's success directly to how well the acquiring company performs, creating a stronger bond of shared interests. For instance, if a tech startup is acquired with an equity-like earnout, the seller becomes a shareholder in the acquiring company, benefiting from any increase in the acquiring company's stock value over time. This arrangement encourages a prolonged partnership and alignment of objectives.
Conclusion
Traditional earnouts face challenges due to misalignments in investment horizons, prompting the rise of equity-like earnouts as a solution. If you have any questions about this alert do not hesitate to reach out to Paul Marino (Partner – Head of the Corporate Group) at 212.573.8158 or via email at pmarino@sadis.com, or to Edward McNelis (Associate) at 212.573.8151 or via email at emcnelis@sadis.com.
