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Mergers & Acquisitions

Beyond the Valuation Gap — Flexing Earnouts in the Current M&A Environment

May 18, 2023
Richard Butterwick, Beatrice Lo, Robbie McLaren, Simon J. Tysoe, Evelyne Girio, Catherine Campbell
Increased use of earnouts is likely to facilitate M&A deals across sectors in Europe.

Earnouts are increasingly common in European M&A. The growing prevalence of this contractual provision — in which additional post-completion consideration is paid based on the performance or satisfaction of targets by the acquired business — comes as parties on both sides of a transaction attempt to address economic uncertainty. Moreover, the willingness of vendors across industry sectors to agree an earnout underlines the current buyers’ market, with greater flexibility offered by sellers and more creative terms reached during negotiations.

Although some claim that an earnout is a failed negotiation, a substantial proportion of recent transactions demonstrate the constructive use of earnouts, particularly in sectors that feature a lag in returns, businesses acquired from individuals and founders, and businesses for which the volatility of commodity prices can impact performance. We have seen a range of earnout methodologies used across multiple sectors to structure around the absence of a target business revenue, market traction, or other typical barometers of success.

As the M&A market adapts to a (hopefully) reviving economy — though one in which inconsistent or unpredictable financial results may continue to feature in target businesses — earnouts may provide a mechanism to unlock the valuation gap between parties.

Metrics Matter

According to the eighth edition of Latham’s Private M&A Market Study, which analysed over 320 deals on which our European offices advised, the use of earnouts has risen in recent years to 19%. The rise of earnouts reflects robust deal volume in sectors that traditionally favour these provisions, such as life sciences, technology, and energy. In these industries, parties have historically found it difficult to reconcile differing financial projections, instead striking a compromise with earnouts based on a range of metrics.

We have seen earnouts based on external (typically non-financial) metrics, such as securing regulatory approval for a new product or being awarded a follow-on or new contract. Earnouts have also used internal (typically financial) metrics, such as achieving a certain EBITDA threshold or gross revenue or net income target, or retaining a set number of employees.

Learnings from these deals are relevant across sectors — and dealmakers are increasingly looking to innovative transaction architecture from other industries in order to get deals done.

Life Sciences

Earnouts are common in the life sciences sector, with metrics such as outcomes of clinical trials, receipt of regulatory approvals, or royalties on net sales featuring frequently. In this sector, valuing a target can be complex due to long research and development phases, clinical trials, and market access to products.

In the current market, biotech companies developing novel products have found it difficult to raise cash on an equity basis, and they face a hugely challenging IPO market. Sellers are increasingly willing to accept earnouts, with provisions usually based on a combination of achieving success in clinical trials, reaching regulatory milestones, and royalties on net sales, measured over several years. With strong demand for immediate capital and a focus on near-term cash flow, company founders are becoming more flexible about allocating value to each milestone. In the US, we have seen an increase in the use of contingent value rights (CVRs), a structure used to facilitate earnouts on public life sciences deals. Structuring a CVR within a UK public deal is possible with careful navigation of the UK Takeover Code rulebook.

Buyers and sellers are also becoming more receptive to risk sharing. Vendors are open to accepting an acquirer’s equity as payment in order to participate in the future upside of a product under the new parent, further highlighting the flexible approach to dealmaking.

Energy

The use of energy sector earnouts has grown amid commodity price volatility and difficulties in setting valuations on an agreed forward curve. Sellers use contingent consideration to receive additional payment if commodity prices rise, whereas buyers try to avoid paying upfront for potential market upside that may never occur. As such, earnouts are typically based on external metrics, such as the average published commodity price exceeding a certain threshold during an agreed period.

Earnouts in the energy space are often triggered by project development and regulatory milestones as projects are de-risked. Earnouts are particularly relevant to energy transition projects in which novel technology and emerging regulation can significantly impact business profitability.

When negotiating an earnout in the energy sector, parties should consider whether buyers should have to pay for incremental production over and above the level the seller was producing at.

Early-Stage Software and Technology

On deals involving early-stage software or new technologies that are yet to achieve significant sales revenues, parties may consider a “build versus buy” earnout metric. We have seen buyers assessing the cost to duplicate the functionality of the seller’s product or technology from scratch versus the cost to purchase the seller and its entire workforce, with an opportunity cost analysis factored into both internal and external earnout metrics.

As such, earnouts based on the “build versus buy” metric are being used as creative alternatives to structure around the absence of conventional metrics, which would otherwise enable a buyer to value early-stage software and other technology companies’ target businesses. Our study found that 33% of deals in the technology sector have featured an earnout in recent years.

Cross-Sector Structures

With a growing range of innovative earnout metrics — and market dynamics in favour of cash-rich buyers — we expect earnouts to facilitate M&A deals across sectors in Europe in the year ahead.

That said, parties should proceed with caution. Earnouts are frequently the most heavily and lengthily negotiated term of deal documentation, and, in our experience, also one of the most frequently disputed. Challenges that made valuation tricky during the deal negotiation period are likely to remain during the earnout period, meaning that expert legal counsel and careful structuring are essential.

Earnout Considerations

If a deal includes an earnout, parties should:

  • Determine the level of obligation required by the buyer to satisfy the trigger.
  • Establish how any payout will be financed; consequent cash-financing needs and covenants regarding ongoing business operations can be problematic.
  • Anticipate subjective areas that may be open to interpretation or may present opportunities for manipulation. Implement specific policies (including accounting policies) to address this — for example, policies on the treatment of extraordinary items or post-completion operational changes.
  • Calculate a pro-forma earnout schedule.
  • Agree an appropriate period over which an earnout will be measured and payable.
  • Understand if stamp duty is payable on any ascertainable maximum earnout consideration. In some jurisdictions, there is no ability to reclaim overpaid stamp duty if less is ultimately required. In addition, a poorly structured earnout can result in an earnout payment to founders or managers being treated as an employment-related payment with negative tax consequences. 

Endnotes

    This Insight is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the lawyer with whom you normally consult. The invitation to contact is not a solicitation for legal work under the laws of any jurisdiction in which Latham lawyers are not authorized to practice. See our Attorney Advertising and Terms of Use.