Earnouts in Mergers and Acquisitions

Part Two: Advantages and Disadvantages

Earnouts in M&A transactions can offer several advantages and disadvantages for both buyers and sellers. Here's an overview of the key pros and cons:

Advantages of Earnouts:

For Sellers:

1. Potential for Higher Valuation: Earnouts allow sellers to potentially receive a higher purchase price if the company performs well post-acquisition. This can be particularly attractive if the seller believes the business has strong growth potential.
2. Alignment of Interests: Earnouts align the interests of the seller and the buyer. Sellers have an incentive to help ensure the company's success during the earnout period because their payout depends on it.
3. Risk Mitigation: Sellers can mitigate the risk of receiving a lower-than-expected purchase price by tying a portion of it to future performance, reducing the immediate impact of any valuation disagreements.

For Buyers:

1. Risk Management: Earnouts help buyers manage the risk associated with the acquisition. They pay a portion of the purchase price only if the company achieves specific performance milestones, protecting them if the company underperforms.
2. Retention of Key Talent: If earnouts involve key employees or management, it can incentivize them to stay with the company during the earnout period, ensuring continuity and expertise.
3. Cash Preservation: Buyers may not have to commit the full purchase price upfront, which can help preserve cash for other investments or operational needs.

Disadvantages of Earnouts:

For Sellers:

1. Uncertainty: Earnouts introduce uncertainty into the transaction. Sellers may not receive the full purchase price they initially expected if the company fails to meet earnout targets.
2. Loss of Control: Depending on the terms of the earnout, sellers may have limited control over the company during the earnout period, which can be frustrating if they are still involved in the business.
3. Disputes: Disagreements can arise over the measurement and achievement of earnout targets, leading to legal costs and potential conflicts with the buyer.

For Buyers:

1. Complexity: Earnouts can add complexity to the deal, including the need for ongoing financial and operational monitoring to ensure the earnout targets are met.
2. Conflict with Sellers: Disagreements with sellers over earnout targets and performance can strain the buyer-seller relationship.
3. Integration Challenges: If sellers are still involved in the business during the earnout period, it can create integration challenges and potential conflicts of interest.
4. Valuation Risk: There is a risk that the buyer may overvalue the business in the initial agreement to secure the deal but then dispute the earnout payments based on overly optimistic projections.

In summary, earnouts can be a useful tool in M&A transactions, especially when there is uncertainty about the future performance of the target company. However, they also come with potential downsides, including complexity, uncertainty, and the risk of disputes. Careful negotiation and clear documentation of earnout terms are crucial to align the interests of both parties and minimize potential issues. Legal and financial advisors often play a significant role in structuring and overseeing earnout agreements.

ABOUT US

Whether you want to sell or buy a business, Chapman Associates provides a personalized service based on our sixty-nine years of successful M&A closings and our relationships with more than 9,600 registered buyers.

Chapman is one of the most respected middle-market M&A firms in the country. What makes Chapman different from the competition?



• We make a market for our clients.

• We do not charge any up-front fees.

• Our fees are based on completed transactions.

• We devote senior-level attention to every M&A transaction.

• We do not delegate work to junior staff.

• We help clients set realistic goals and work hard to exceed them.

• We conduct in-depth research and rigorous analysis.

• We prepare all necessary offering materials.

• We have ten offices nationwide to serve our clients.

Mark Mroczkowski, CPA, CM&AA

Managing Director 

mark@chapman-usa.com

www.chapman-usa.com

407.580.5317