STRUCTURING DEALS – EARNOUTS & ROLLOVER
by Jennifer Tetreault | 09 Nov 2021
In today’s hot Mergers and Acquisitions (M&A) market, deal negotiations have become increasingly more competitive. Earnouts and contingent rollover equity can be effective tools for bridging the valuation gap, sharing risk between the buyer and the seller, and addressing key person exposure. This article discusses key considerations when structuring earnouts and contingent rollover equity as well as the trends we have observed in the market over the past two years related to each.
STRUCTURING AN EARNOUT
Since the emergence of COVID-19, the Intrinsic team has seen a significant increase in earnouts included in private equity transactions. At the onset of the pandemic, earnouts were used to bridge the valuation gap between buyers and sellers. Due to increased market uncertainty, buyers were faced with unprecedented challenges related to predicting future performance scenarios of target companies. To compound this predicament, there was almost universal multiple expansion in completed transactions, primarily due to record amounts of private equity capital deployment and valuation efficiencies stemming from a marked increase in intermediated transactions. To remain competitive, many investors introduced larger degrees of contingency mechanisms in their purchase consideration. This was a way to share risk with the sellers by accommodating disagreeable expectations around future financial performance with purchase prices that had to pencil out to certain Multiple on Invested Capital (MOIC) and Internal Rate of Return (IRR) hurdles.
Now that business has returned to more normalized levels, and the M&A market has become highly competitive for buyers, earnouts are increasingly serving more as targeted incentive and retention mechanisms for key members of the management team. To entice sellers and provide strong support for the realizable value of these forms of consideration, buyers are setting reasonably achievable milestone targets and committing to supporting the business to achieve those milestones. This offers sellers the potential to share in the reward of future performance in addition to attaining ambitious valuations.
SELECTING THE PERFORMANCE METRIC
Earnout metrics are quantifiable measures that buyers and sellers can use to track, monitor, and assess the performance of the target company following the acquisition. In general, metrics fall into two categories: financial and non-financial.
The most common financial metrics used by buyers are revenue and/or Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). In general, sellers prefer a revenue-based metric, as it is easier to achieve, easier to calculate, and less susceptible to buyer manipulation. Buyers, however, generally prefer EBITDA, as it is a more accurate indicator of the target’s performance and captures the risk of earnings volatility that is excluded by revenue-based metrics.
Often the valuation methodology used by the buyer to value the target drives the decision of what metric should be used. If a multiple of EBITDA was applied, and the buyer estimates that the target will likely be evaluated on EBITDA at exit, an EBITDA-based metric would be logical, as it aligns buyer and seller motivations over the holding period. Within the SaaS industry, it is typical to see earnouts that include monthly recurring revenue or annual recurring revenue metrics for this reason.
Financial metrics can be more complex depending on the target’s size, industry, and company-specific risks. Some of the complex financial metrics Intrinsic has recently encountered include:
- A SaaS company was in the deal negotiation process with multiple prospective clients prior to their acquisition. If the clients were acquired, they would serve as a significant source of revenue for the target. To incentivize the sellers to close the deals, individual earnouts were attached to the acquisition of each prospective client. Each client had its own threshold, cap, and maximum payment based on the stage of negotiation the respective client was in and the estimated revenue that would be derived from the client.
- In an add-on acquisition, an earnout was included that was based on a successful IPO of the buyer with net equity proceeds of $1 billion and proceeds to the private equity sponsor in excess of $500 million.
- A buyer and seller were stalled in deal negotiations for a commercial real estate company. The buyer believed the decreased occupancy rates the target was experiencing were short-term. However, the buyer wanted to hedge the downside risk of continued low occupancy rates following the acquisition. Accordingly, an earnout based on an occupancy rate performance metric was added to the purchase agreement. The threshold occupancy rate was set to align with the target’s average occupancy rate for the prior year. For each percentage increase in the target’s occupancy rate above the set threshold, the earnout payment would increase.
- A consumer products company was one year into a deal negotiation with a new distributor. The seller believed the deal would be closed within a few months, while the buyer estimated negotiations would take considerably longer, as the risk of closing the deal was significant. As such, an earnout based on the sale of the target’s existing products through this distributor was added. The earnout would be measured over four separate calculation years with a constant threshold of $5 million in revenue for each respective year. For each dollar in excess of $5 million achieved by the target during each of the measurement years, the seller would receive 20%.
In certain cases, non-financial metrics are more appropriate given the perceived risks of the target’s future performance. Non-financial metrics we have encountered include:
- Customer retention
- Employee retention
- Product development milestones
- New product launches
- Regulatory approvals
- Resolution of legal disputes
- Closing of a future acquisition
DETERMINING THE EARNOUT PERIOD
Selecting the appropriate earnout period is a key consideration for both buyers and sellers. Short earnout periods can incentivize short-term behavior to the detriment of long-term results. Long earnout periods can delay full integration of the target and increase the risk to the seller.
Historically, earnout periods typically range between one and three years. During the pandemic, we saw an extension in the length of earnout periods. Given the unpredictability of when businesses would resume normal operations, three-to-five-year earnout periods became more common. Further, additional stipulations regarding the start of the earnout measurement period were added. For example, an earnout included within the acquisition of a medical practice included a measurement period that would begin one month following the resumption of elective medical procedures.
STRUCTUING THE PAYOFF STRUCTURE
- Milestone Payment: An absolute milestone must be achieved before a payment is made.
Example: The sellers project EBITDA of $80 million in FYE 2022, 40% above reported FYE 2021 EBITDA. The buyer estimates the expected EBITDA growth rate is aggressive, so an EBITDA-based earnout is added to the purchase agreement. If EBITDA equals or exceeds $80 million, the full value of the earnout will be paid. If EBITDA is less than $80 million, no earnout will be paid.
- Graduated Milestone Payments: A series of gradually increasing milestones with corresponding earnout payments.
Example: The sellers plan on staying in the business following the transaction, but with limited involvement. To incent the sellers to be more invested in the future of the target, an earnout structured with multiple thresholds is added to the purchase agreement. If Annual Recurring Revenue (ARR) is less than $50 million, no earnout will be paid. If ARR is greater than $50 million but less than $55 million, the sellers will receive $2 million. If ARR is greater than $55 million but less than $60 million, the sellers will receive $3 million. Finally, if ARR is greater than $60 million, the sellers will receive the maximum earnout allowable, $4 million.
- Threshold of Zero and No Cap: The earnout payment is equal to a fixed percentage of the outcome for the performance metric.
Example: Prior to the acquisition date, the seller is nearing the end of a two-year negotiation process with a prospective client who, if closed, would be a large source of revenue for the target. To incent the seller to continue working towards closing the deal, an earnout is added to the purchase agreement based on revenues derived from the prospective client. For each dollar of revenue earned from the client, 2.5% is transmitted to the seller.
- Percentage of Total Above a Threshold: The earnout payment is equal to a percentage of the excess above a threshold.
Example: Without the seller’s involvement, the buyer estimates that revenue will be $20 million next year. However, if the seller continues with the company the buyer estimates the target company will be able to achieve revenue of $30 million. To incent the seller to continue working in the business, an earnout is added with a threshold of $20 million. After $20 million of revenue is achieved, the buyer will receive 5% of revenue above the threshold.
- Percentage of Total Above a Threshold with a Cap: The earnout payment is equal to a percentage of the excess over a threshold with a cap on the total possible payment.
Example: The buyers are projecting next fiscal year EBITDA of $10 million while the sellers are projecting next fiscal year EBITDA of $15 million. To get the deal across the finish line, the buyers add an earnout to the purchase agreement that includes an EBITDA threshold of $10 million. For every dollar of EBITDA above the threshold, the sellers will receive 30% with a maximum payment of $1.5 million.
Clear guidelines on measuring the performance metric should be established as part of the negotiation process. Agreeing that the metrics will be measured in accordance with Generally Accepted Accounting Principles (GAAP) is insufficient. GAAP provides malleable guidelines that can allow the preparer of the financial statements to select the most favorable treatment that suits their agenda. Key accounting considerations include:
- Use of cash revenue vs. accrued revenue
- Timing of revenue recognition
- Treatment of uncollected receivables
- Treatment of non-recurring items and transaction expenses
For add-on acquisitions, it is also important to consider the treatment of synergies. If it is anticipated that the target will benefit from consolidated general and administrative expenses, these expenses may be passed along to the target based on market prices for the services provided or historical pre-transaction expenses of the target. Sellers should consider the post-close allocation of executive compensation and management fees.
It is important to address how post-close control will be allocated between the buyer and seller and what level of support the buyer will provide the target with. Buyers typically desire flexibility so they can operate the business according to their investment thesis. Sellers generally want to retain some level of control over the operations of the target to ensure achievement of the maximum earnout payment available. To mitigate buyer and seller tension, restrictive covenants that set limitations on buyer interventions and provide guidelines for required buyer support can be added to the agreement. Examples include:
- Seller approval rights for major decisions
- Requirements to operate the target consistently with pre-close operations
- Restrictions on discontinuing products or services
- Accelerated payment if substantial changes to the management team are made
- Assurances that adequate capital will be available to the target
- Capital expenditure caps and thresholds
- Sales and marketing caps and thresholds
- Add-backs for expenses beyond predetermined bounds
- Requirement that buyers invest a certain level of effort into the achievement of the earnout
Earnouts serve as a great tool to break pricing deadlocks and reallocate risk. An acceptable earnout will satisfy the demands of both the buyer and the seller. However, it is also important to consider the long-term risk of disagreement following the close of the deal. With each increase in the complexity of the metric calculation, or the duration of the earnout measurement period, the more likely it is that a disagreement between a buyer and seller will become a formal dispute. Further, the all or nothing milestone approach can lead to more contentious measurement when compared to sliding scale earnouts. To avoid potential disputes, the terms surrounding performance metrics, payment calculations, and measurement should be clearly defined and carefully negotiated. Arbitration procedures should be included within the terms of the agreement so potential disagreements can be addressed in a fair manner.
STRUCTURING ROLLOVER EQUITY
Rollover equity is common in private equity platform investments as well as significant add-ons. It aligns the goals of the buyer with the goals of the seller, mitigates key person risk, and reduces the cash outlay for buyers. The seller benefits from partial liquidity while still maintaining an interest in the target’s upside, representing the proverbial “second bite at the apple.” Further, the rollover equity can be structured on a tax-deferred basis. Rollover equity structure can serve as an additional lever within deal negotiations to either a) get the deal across the finish line with hesitant sellers, or b) mitigate risk for cautious buyers.
The structure of rollover varies from transaction to transaction and is impacted by the following key factors:
- Seller’s vs. buyer’s market
- Historical performance of the private equity firm
- Strength of the target’s management team
- Availability of capital within the market
Typical rollover equity structures are as follows:
Subordinated Equity: In this structure, the buyer receives preferred equity while the seller receives common or subordinated preferred equity. Variations of this structure ranked from most favorable to the buyer to least favorable are as follows:
- In a liquidation scenario, the buyer participates first, receiving their contributed capital in addition to a cumulative return on their investment. Following participation of the buyer, the rollover unitholders receive their contributed capital. Next, the preferred and rollover unitholders participate pro rata. This structure is becoming exceedingly rarer in today’s hot market. In recent cases where Intrinsic has encountered this structure, either a) the target did not have a significant number of other bidders, or b) the target was operating in an unproven market that required substantial capital to achieve its long-term vision.
- In a liquidation scenario, the buyer participates first, receiving their contributed capital in addition to a cumulative return on their investment. Following participation of the buyer, the rollover unitholders receive their contributed capital and a cumulative return on their investment. Next, the buyer and rollover unitholders participate pro rata. This structure is comparable to the buyer receiving senior debt while the seller receives subordinated debt. It provides significant downside protection to the buyer while also providing upside protection that varies based on the percentage of the transaction that is comprised of rollover equity. This structure is also rare, although we do see it in cases where the private equity firm is highly skilled within the niche industry it is investing in and significant operational efficiencies are expected to be captured.
- In a liquidation scenario, the buyer participates first, receiving their contributed capital. Following participation of the buyer, the rollover unitholders receive their contributed capital. Next, the buyer and rollover unitholders participate pro rata. This structure remains relatively common within private equity, even in this hot market. It is typical among private equity firms with strong brand recognition and a proven track record.
Equivalent Units: In this structure, the seller receives equity with the same rights and preferences as the equity held by the buyer. This is the most common structure Intrinsic encounters. Although the classes of units might differ, the economic rights are equivalent.
Vesting Rollover: In this structure, the seller receives rollover equity that vests according to MOIC requirements. If the buyer receives an MOIC below the stated threshold (typically 2x to 5x), the rollover equity is worthless upon an exit event. This structure is very rare and has only been seen within strategic add-on investments in early-stage companies. It is more comparable to contingent consideration and the issuance of management incentive units.
As the result of the expected increase in the capital gains tax rate, we estimate that sellers will now prefer that a larger percentage of total purchase consideration be allocated to rollover equity versus previous trends. This could benefit private equity firms by increasing the alignment of buyer and seller goals and further mitigating key person risk. Given the sellers’ preference for rollover equity in lieu of cash, private equity firms may be in an improved negotiating position that will allow for buyer-favorable rollover equity structuring.
// ABOUT THE AUTHOR
Jennifer serves as a Director within the Valuation practice at Intrinsic and is responsible for business development and project management. She has completed engagements valuing businesses, equity securities, and intangible assets for a variety of purposes, including financial reporting (ASC 805, ASC 350, and ASC 718), corporate tax (IRC 409A), gift and estate, portfolio valuations, litigation and dispute resolution, and financial opinions. Jennifer has experience working with senior management of private and public companies of all sizes and various industries, with a focus on the technology sector.
Prior to joining Intrinsic, Jennifer worked for Benson Mineral Group, an oil and gas exploration and investment firm. During her time at Benson Mineral Group, she was responsible for auditing revenue streams, analyzing investment opportunities, and valuing oil and gas assets in addition to various accounting responsibilities. Jennifer graduated Summa Cum Laude from the University of Colorado, Denver, with a double major in Financial Management and Risk Management. She has passed Level II of the CFA program.