Why are there earnouts?

I was at a presentation recently on M&A exits for business owners. The question of earnouts came up, but although the panel was generally well-informed (I work for one of them, the managing partner of my firm, and with another, an accountant who works with several of our clients), they never clearly stated the fundamental more banker-y and corporate finance reason why there are earnouts: disagreements about price, which are grounded in disagreements about risk.

The classical seller knows the company well and has an intuitive, if not explicit, understanding of the pace of the business, the incoming and outgoing contracts with customers, and the projected needs of those customers.

The buyer, in contrast, knows only what’s on the papers provided in diligence – historical financials, projections, and customer contracts – and the results of any additional investigation into what customers are doing or will do or what suppliers are doing or will do.

In virtually all cases, this discrepancy means that sellers have less risk embedded in their projections about the future results (there’s also, of course, a substantial effect from confirmation bias and the endowment effect). Buyers are less certain about the price and have to justify the valuation more explicitly (if they’re doing it right).

Often, there’s a gap between what the buyer calculates based on projections and the buyer’s perception of risk on the one hand and the seller’s asking price on the other hand.

As I tell my colleagues and clients, due diligence problems trigger one of three responses:
– a change in price
– a change in terms
– killing the deal

This disagreement about price and value can be solved in a few different ways. The seller wants the buyer to simply adopt the seller’s risk position and effectively assume the risk that the seller is incorrect. The buyer wants no part of this and is typically unwilling to assume more risk than the buyer is comfortable with.

To bridge this gap, since neither of those solutions is common unless there are external factors that create additional leverage in negotiations, I put on my finance hat and bridge the gap with an earnout. The earnout is, strictly speaking, a purchase price adjustment based on certain specific performance goals.

(There are additional incentives that are often lumped into the earnout category, but it’s not necessary now to really dig into the precise incentives at play in all the variations on the earnout theme.)

At its simplest, an earnout might say that if the company achieves $X revenue in some defined financial period, the seller will get $Y additional purchase price. This is a mechanism for allowing the seller to gain additional consideration without transferring the associated risk to the buyer. The buyer is essentially buying reverse insurance – not paying more today but instead paying later if it turns out the buyer does make a big gain. This risk allocation about future results and the effect of those results – at the time of sale or in the future – on the deal price is the heart of the problem that earnouts exist to solve.

Not convinced? Think about transactions where there are few earnouts – bond trades, security trades, sales of public companies; and where there are many: employment contracts for sales people, placement agent agreements, and investment banking engagements. The commission is the same thing as an earnout – it’s an allocation of the risk to one party in exchange for the non-bearer accepting that a higher payment is appropriate later because the risk is gone – after all, I’m much more willing to pay for a guaranteed sale of a $50,000 car than for your efforts at selling the car that may or may not be successful.