Bass, Berry & Sims attorney Tatjana Paterno was featured in an article published on the Mergers & Acquisitions Magazine website, www.themiddlemarket.com, discussing the use of earnouts in M&A negotiations to bridge the valuation gap between the expectations of buyers and sellers.
When buyers and sellers are in disagreement over the value of the sellers’ business, earnouts offer a solution. Namely, sellers can receive additional compensation after the deal closes when the business reaches certain financial targets, which allows buyers to limit risk by paying less up front and more once financial expectations are met or even surpassed. Valuation discrepancies have been pervasive following the pandemic and ahead of uncertain economic forecasts, which have led to a rise in popularity of earnouts to help finalize transactions.
“Based on what I am seeing in my practice and feedback from investment bankers, private equity professionals and other M&A attorneys, the use of earnouts has certainly increased in recent months,” Tatjana said.
She added that the earnouts uptick has been driven by the buy-side of M&A deals. “The uncertain economic environment reduced visibility into the anticipated performance of acquisition targets, which resulted in an adjustment of buyer expectations with respect to valuations,” Tatjana stated. “Buyers have taken a conservative approach to valuation, offering earnouts to reduce the risk of potential underperformance.”
While they are helpful for bringing sides together to close deals, they are not without risk of potential disputes in the future. “The bigger the earnout is (as a percentage of purchase price), the higher the stakes,” Tatjana said. “Clarity around applicable earnout metrics (e.g. revenue, EBITDA), earnout period (typically 1-3 years), payout formula, measurement standard (i.e., GAAP and exceptions to GAAP), post-closing covenants — are all very important. Any assumptions that are made should be spelled out to avoid future disputes. Clarity is the best protection against future disputes.”
The full article, “Earnouts Bridge the Expectation Gap Between Buyers and Sellers,” was published February 8 and is available online.
Tatjana will also be participating in an event providing further insight on the current state of deal negotiations on February 23, when she moderates a panel at an Association for Corporate Growth Tennessee meeting titled “Dealmakers’ Perspectives on Negotiations and Relationship Building.” More information on that event is available here.