NEWS

Use of Earnouts Has Jumped in Challenging M&A Market

“New data released this week from Bloomberg Law show the use of earnouts, or a contingent consideration in transactions, remains well above historical trends. Both earnout transaction volume and number of deals are peaking, particularly as a percent of total M&A activity.

Earnout Structures

An earnout allows the buyer of the target company to delay a portion of its payment until certain conditions are met at some point after the transaction closes.

For buyers, it’s an opportunity to de-risk the acquisition and lower the up-front purchase price.

Historically, earnouts have been most popular in biotechnology deals where a majority of the target’s value is unlocked (or lost) following clinical trial readouts or an FDA decision. Tying part of a takeover offer to the achievement of such milestones can help mitigate a portion of the binary risk.

Outside of clinical trial outcomes, other external earnout metrics can include successful contract renewals or new product launches, while internal (often financial) metrics may be tied to the achievement of certain EBITDA or revenue thresholds.

Earnouts à la Mode

“I’ve literally seen an earnout involved in every deal I’ve worked on in the last year,” Liam Timoney, a partner in Goodwin’s private equity group, tells Bloomberg Law. “If it’s not been ultimately featured, it’s still definitely been considered, and it’s been part of the negotiation.”

Use of earnouts in M&A has jumped in 2023 and 2024

Last year’s earnout incidence is particularly notable given the overall drop in dealmaking. Separate data from SRS Acquiom found that nearly one-third of private equity deals included an earnout through the first three quarters of 2023, up from 21 percent in the same period a year earlier.

Alongside what may be a secular trend, earnouts can be most helpful in sluggish M&A environments. The structure can help bridge the gap when there’s a mismatch in valuation between the buyer’s offer and the seller’s expectations.

With sponsors feeling the pressure on their ability to pay (higher rates), coupled with stubbornly high private markets valuations (or at least sellers who are fine to hold out), earnouts provided some possibility of middle ground.

Similarly, in less competitive processes with fewer parties than in prior years, a seller may find they’re left without the negotiating power to avoid an earnout.

 

Potential for Litigation

Usage of earnout provisions often means lengthier deal timelines and higher legal bills. Parties need to agree on the amount of the earnout, its criteria, and the specific definitions of particular milestones.

Beyond alignment on details such as accounting methodologies, each side must anticipate subjective areas that may be open to interpretation or manipulation—treatment of extraordinary items or post-close operational changes, for example.

Even absent documentation issues, earnouts can be an unattractive proposition for sellers. On top of the timing delay (and uncertainty) for their proceeds, there’s the consideration that they’ll likely lose much of their ability to influence the future performance of the business.

With so much at play, earnouts are often contested, and related litigation has grown in lockstep with their use. In the first quarter of 2023, more than four times as many dockets mentioning earnouts were filed in the Delaware Chancery Court compared to the same period a year earlier.

Discontent is especially likely for sellers, for whom the perceived loss of headline transaction value can be an emotional hot point. Issues also tend to surface when the seller is within touching distance of objective achievement yet falls just short.

Sam Hillier

Sam Hillier is a reporter at Transacted covering private equity and investment banking. He previously spent time as an investment professional focused on direct buyouts, as well as an earlier strategic advisory stint.

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