As the continuing economic uncertainty slows or stalls deal processes, the increasing M&A price expectation gap has paved the way for more use of earn-out clauses to bridge the widening gap between buyers’ ambitions and sellers’ hopes around price. PwC data published in its Global M&A Industry Trends: 2023 Mid-Year Update suggests that M&A deal values in the first half of the year totalled just £42.8bn in the UK – down by 55% on the same period of 2022. Volumes proved more resilient, but still fell 21%.

“A prolonged period of low interest rates and high demand for acquisitions has set sellers’ value expectations at historically high levels,” says Paul Joyce, head of the London M&A team at Mazars. “Conversely,” he continues, “the increased uncertainty in the financial markets has caused buyers to become more cautious. This combination has caused the expectation gap to widen significantly over the past six months.”

In such a climate, dealmakers and advisers must work harder to get transactions over the line. Research from CMS revealed that about 23% of UK deals completed in 2022 featured some form of earn-out clause – the highest proportion ever recorded in the law firm’s annual surveys of M&A, which go back to 2010. The percentage for 2023 looks set to be even higher.

In timely fashion, this month the Corporate Finance Faculty, together with Grant Thornton, has published its latest guide: 'Earn-outs: How to avoid the pitfalls and achieve a successful transaction earn-out'. “Earn-outs can be a really useful facilitator for a deal where there is a valuation gap to overcome,” says Patrick O’Brien, partner and head of SPA advisory at Grant Thornton, and co-author of the guideline. “But they must be negotiated extremely carefully.”

The principle of an earn-out is simple enough. The seller pays a sum upfront for the acquisition, with an additional premium – say 20% – payable only if the business hits agreed targets within a set timeframe. The targets could be financial – a fixed amount of revenue or EBITDA, for instance. They might also be non-financial – potential metrics include anything from the retention of a key contract to a target level of customer satisfaction.

“The goal is to de-risk the transaction for both parties,” explains O’Brien. “The possibility of the buyer overpaying for the business is reduced, but the seller knows it will achieve a fuller price if the business performs to its potential.” At times such as now, when a volatile market backdrop means reduced visibility for most businesses, that de-risking is particularly attractive.

Back on the table

Chris Watt, a managing partner at ECI Partners, says private equity buyers are certainly making more use of earn-outs. “Until relatively recently, there was a perception that they could be more trouble than they were worth, but they have definitely come back on to the table over the past 12 months,” he says.

Valuation expectations have widened across the market, he points out, but agreeing a price for the smaller and earlier-stage businesses that PE buyers often look for can be especially difficult in this marketplace. “These are businesses that are growing very rapidly and the vendor wants to capture some of that future value today,” he says. “An earn-out can be one way for the buyer to offer some compromise in that situation.”

Trade buyers, longstanding users of earn-outs, are also using these mechanisms more frequently. Chris Hunt, group M&A director at Rentokil Initial, says that of the 40-50 transactions completed by the pest control and hygiene business each year, roughly 80% include some kind of earn-out clause. For Rentokil, such clauses provide a means to align their interests with those of management teams at the businesses it is acquiring.

“The businesses we buy are often developed by entrepreneurial founders and managers, so we’re keen to keep them with us,” he explains. “These also tend to be businesses with loyal customer bases, so we want management to ease the transition as those customers become Rentokil customers.”

Given those drivers, Rentokil typically structures its earn-out clauses with a combination of financial and other metrics, Hunt explains. The latter might include a requirement that the business retains a certain percentage of its customers, or that key members of staff remain with the business.

Financial targets can be tricky to agree, Hunt adds. “Setting the targets is challenging – what level of synergies with our business do we assume and what might be the impact of new ways of working? How do we anticipate other costs or changes to the business?”

It’s a warning that speaks to some of the potential problems with earn-outs. “One of the reasons earn-outs weren’t fashionable prior to the recent bout of uncertainty is that they can be fraught with difficulties,” says Clive Hatchard, partner at FRP Corporate Finance. “You’re not getting a clean break from the deal and that can create issues for vendor and purchaser alike.”

For vendors, accepting an earn-out means there is no certainty about how much they will receive from the deal. Worse, with the company under new ownership, they may find that their ability to steer it towards the targets set by the earn-out are compromised – the new owner may not give them the freedom they feel they need to work towards those aims. “You’re now working to achieve something over a period when you’re not in full control, which can be a difficult pill to swallow psychologically,” says Robert Baxter, KPMG UK head of corporate finance. 

Not all sellers remain with the business, in which case the loss of control is complete. Vendors might also fear that an earn-out that’s focused on profitability, say, might tempt the purchaser to load costs on to its new business and undermine the bottom-line performance. Of course, a carefully written sales and purchase agreement (SPA) can mitigate much of that risk. But even where the purchaser behaves with complete integrity, unexpected events can blow the business off course.

Change for the better?

As for the acquirer, the big downside to an earn-out is that it may limit their ability to make the changes they want following an acquisition. M&A activity may be difficult, for example. “The buyer will typically be expected to leave the business largely intact,” explains Hatchard. “In some deals, that may undermine the point of making the purchase in the first place.”

In addition, points out Baxter, it can be difficult to work out how much of the business’s success during the earn-out period reflects its qualities prior to its sale, and how much is down to any improvements that the buyer has made – cost reductions from synergies, for example. “Buyers don’t want to feel they’re paying the seller for financial outcomes they themselves have generated.”

Given these issues, earn-outs are not ideal, argues ECI’s Chris Watt. “There’s no getting away from the fact that an earn-out is a bit of a fudge – it means you’ve failed to reach a clear agreement on price,” he says. “At some point, there does need to be a recognition on both sides that the transaction is a transfer of risk and reward from one party to another, and an earn-out dilutes that.”

Earn-outs being stretched over a long period are often not ideal, as they can stymie a business’s ability to make opportunistic acquisitions.

Make it work

Nevertheless, with uncertainty at the fore and earn-outs becoming more common, dealmakers must find ways to mitigate any problems with these clauses. Duration of the earn-out is one crucial consideration, argues Hatchard, with these clauses typically ranging from a few months to a number of years. “A shorter earn-out period is generally better because there are simply fewer uncertainties to deal with,” he says. “In most cases, it also makes sense to set financial targets related to metrics as far up the profit and loss account as possible.” Revenue-focused targets are much clearer cut than those related to profitability, where the calculation includes more variables, although they may not be suitable in all cases.

Another important decision is whether to go for an all-or-nothing target, where the vendor will receive the additional payment in full for beating the earn-out target, but gets nothing if it is missed. “These are simpler clauses, but they create a cliff edge,” warns Edward Orme, a director in Grant Thornton’s SPA team. “That can cause tension, so it may be preferable to agree a sliding scale.”

The key, adds Orme, is to be crystal clear about the provisions of the earn-out in the SPA. “You would expect to see financial clauses in any deal, but these are especially important where an earn-out is involved,” he says. “In practice, both sides should be discussing at least the outline of these provisions well before they start drafting the agreement, with professional advice.”

Without such support, there are bear traps – one is agreeing the accounting standards that will be applied to the earn-out calculation. The UK has GAAP rules on revenue and lease accounting, for example. The existing or future rules may be fine, but both parties must understand any implications.

Best intentions

Inevitably, agreeing an earn-out is a negotiation, but there needs to be goodwill on both sides, argues Mark Cunanan, Grant Thornton director and SPA post-completion services leader at the firm, and co-author of ICAEW’s upcoming guide. This goodwill is particularly important where the vendor’s management team will be staying on following the deal completion. “The provisions need to be thought out in as much detail as possible with a clear intention not to disadvantage one party or the other,” he says. “Any ambiguity increases the likelihood of a dispute later on.”

That’s not to say all disputes can be avoided. “They occur most commonly when the business’s results are borderline,” says Cunanan. In such cases, both sides are bound to look very closely at any wriggle room enabled by the SPA. “Another familiar argument is whether there have been significant changes to the business,” he adds. While the business conduct provisions in the SPA should clearly set out what the buyer can do with the business once it has gained control, plans may change and it is difficult to anticipate every eventuality.

In some cases, buyers may be prepared to renegotiate post-deal. “There may be the potential to extend the earn-out,” says Grant Thornton’s O’Brien. “Or the buyer may agree that the business has changed to a greater extent than was expected, perhaps because of an external factor.” The COVID-19 pandemic, for example, prompted a number of such discussions.

However, the goal should be to reduce the risk that a renegotiation will be needed. This can be done by defining the earn-out as tightly as possible at the outset. When both sides are transparent and open from day one, it is much harder later on for either party to claim they have been unfairly treated.