What Is an Earnout?
An earnout is a provision in a contract that offers extra payment to sellers if specific performance goals are achieved. This clause is commonly used in business transactions such as mergers or acquisitions (M&A)1. An earnout typically involves a structured payment plan where a portion of the total purchase price is contingent upon achieving specific financial or operational targets over a defined period after the sale. These targets might include metrics such as revenue thresholds, EBITDA (earnings before interest, taxes, depreciation and amortization) goals, or customer retention rates. In summary, earnouts are valuable tools in M&A transactions, balancing the interests of buyers and sellers. By tying a portion of the purchase price to future performance, earnouts can facilitate smoother negotiations and foster a collaborative environment post-acquisition.
When it comes to the transaction value, that term refers to the total worth attributed to a business in the context of a merger or acquisition (M&A), encompassing all forms of consideration exchanged between the parties involved. It reflects the comprehensive value that the buyer is willing to pay, considering both cash and non-cash elements, including any contingent payments or earnouts.
In broad terms, the Transaction Value can be calculated using the following formula based on the Enterprise Value (EV) approach:
Transaction Value = Equity Value + Debt – Cash + ITM Options/Warrants + Contingent Consideration
Equity Value is the market value of the company’s equity. Debt represents the total of any outstanding liabilities. Cash is the cash and cash equivalents held by the company. Contingent Consideration includes any future payments that depend on achieving certain performance metrics or milestones post-transaction.
Agencies in the market, such as LSEG, Dealogic, and Mergermarket, often base their valuations on the cost to acquirer approach. This entails assessing all costs incurred in the acquisition process, including Transaction Value, to provide a comprehensive view of what the acquirer is willing to invest to obtain control over the target business. This method emphasizes the total financial commitment, including both immediate costs and future obligations, ensuring a thorough understanding of the transaction’s economic implications.
Deal agencies typically assess these transactions, such as the Merck and Daiichi Sankyo collaboration,2 by considering both the upfront payment and any contingent earnout figures. This approach provides a view of the transaction value and reflects the total financial commitment involved.
In evaluating such deals, the transaction value is generally calculated as follows:
Upfront Payment: This is the immediate cash payment made at the outset of the agreement. In the Merck-Daiichi Sankyo deal, this amount is $1 billion. This upfront investment signals the acquirer’s commitment and serves as a foundation for the deal’s overall valuation.
Contingent Consideration (Earnout): This includes potential future payments contingent on achieving specific milestones, such as regulatory approvals or sales targets. In Merck-Daiichi Sankyo’s case, the earnout figure can reach up to $6 billion, depending on the success of the ADCs. This component is crucial as it reflects the anticipated future performance and value that the collaboration may generate.
Thus, when databases like LSEG, Dealogic, or Mergermarket report on such transactions, they typically sum the upfront payment and the earnout potential to arrive at a total transaction value:
Total Transaction Value = Upfront Payment + Earnout Potential
For the Merck-Daiichi Sankyo collaboration, this translates to:
Total Transaction Value = $1 billion + $6 billion = $7 billion
Earnouts are particularly beneficial in situations where there’s a dispute between the purchaser and the vendor regarding the future financial performance of the business or anticipated shareholder returns. As they offer a type of conditional payment based on performance, earnouts are frequently seen in rapidly expanding sectors where income and profits might be more uncertain. They are a common feature in M&A transactions, where the main purpose of earnouts is to bridge the valuation gap between the buyer and the seller by tying a portion of the purchase price to the future performance of the acquired business.
This conditional payment structure aligns the interests of both parties, providing the seller with the opportunity to achieve a higher total sale price if the business performs well post-acquisition, while also protecting the buyer from overpaying for an underperforming asset.
Earnout provisions have become increasingly prominent in private equity deals, as well as within the healthcare, real estate and industrial sectors. According to S&P,3 five out of the ten largest private equity-related M&A transactions that included earnout provisions targeted companies within the healthcare sector in 2023.
Benefits of Earnouts
1. For the buyer, an earnout gives more time to complete the transaction than having to pay for everything upfront. If business revenue turns out to be lower than anticipated, the buyer won’t have to pay as much. The total price paid for the acquisition can be based on the company’s future performance rather than a projected or estimated performance, thus minimizing the risk of the buyer overpaying.
2. For the seller, an earnout allows the ability to spread out tax payments over several years, easing the impact taxes may have on the sale and increasing the chances of a successful deal.
3. They provide flexibility over the structure of a deal, while providing sellers with a means for realizing additional, post-acquisition value if the business outperforms expectations.
4. They provide a mechanism to bridge gaps in valuation expectations between the buyer and seller, facilitating a smoother negotiation process.
5. Earnouts can help to mitigate the buyer’s risk by tying a portion of the purchase price to future performance. They can also mitigate risk of underpayment for the seller, with contingent payments due if the business performs well post-acquisition.
Drawbacks of Earnouts
1. For the buyer, it could be that the seller continues to be involved in the business and tries to influence the day-to-day running for an extended period, which could give rise to disputes with the buyer and create disharmony in the workplace.
2. The seller could also be at a disadvantage if the future earnings of the business fall short of financial predictions set out in the earnout. If this happens, the seller won’t make as much from the sale of the business as they might have expected.
3. The inherent unpredictability of future business performance introduces uncertainty into earnout agreements, posing a challenge in accurately estimating potential payouts.
4. There are often differences in opinion on the appropriate performance metrics and measurement methods to use in an earnout clause. Sellers should be watchful for any unorthodox application of accounting principles.
Duration
Key Earnout Milestones
The financial metrics used in earnouts usually require the achievement of EBITDA, gross revenues, or gross profits. Sellers are more inclined towards performance metrics based on revenue, as they are less influenced by costs and the accounting practices of the buyer after the deal is closed. On the contrary, buyers favor performance metrics based on income, as these can provide a more accurate measure of the business’ success.7
EBITDA is a frequently utilized financial performance indicator. It’s often used to calculate the total purchase price as a multiple of EBITDA, making it a useful metric for earnout calculations. However, EBITDA is not recognized under the Generally Accepted Accounting Principles (GAAP) and may not appear in the business’ historical financial records. Therefore, it’s crucial to clearly define what should be included or excluded when calculating EBITDA in the agreement.8
Earnouts can also be structured around non-financial goals such as maintaining a given number of employees, gaining new customers, the success of clinical trials or FDA approval. The goal will be tailored to the specific deal and industry.
Legal Involvement in M&A Earnouts
Parties involved in an earnout transaction agreement will have to navigate across multiple clauses and obligation items. The list of considerations is limitless, and the process can get rowdy. Both sides of the deal must act in good faith and always ensure fairness, but of course, both sides will also want to get the bigger cut of the cake, which could lead to hostility and disputes. The buyer could intentionally sabotage the metrics which would trigger earnout payments, or the seller could ignore the authority of the buyer. To ensure success, both parties must look for balance and take care to ensure clarity around who will bear the burden of proof, whether that burden can be shifted, as well as analyzing the discretion, effort and intent of the parties or the reasons for their actions.
Since the earnouts are a contractual instrument, the same contract must stipulate clear covenants and protective provisions as well as a mechanism to settle any controversy, which could go from confidential binding arbitration (out of court) up to litigation.9 Arbitration panels provide a means to resolve conflicts without the need to use standard (state) courts, incur legal costs, and use up staff and management resources.10 In order to prevent issues, a dependable assessment of performance that both parties can have faith in is necessary.11 An arbitrator, also known as an expert determination, is a neutral third party who serves as an authority on any disputes regarding the performance targets, the extent of the parties’ power, or the process of adjudication.12
Earnouts across Industries
In recent years, earnouts have become an increasingly prevalent feature in market transactions. The following analysis highlights the rising trend of earnouts in the market from 2014 to 2023, based on data from LSEG.
The percentage of total market value involving earnouts has generally increased over the years. For instance, in 2014, earnouts represented 3.1% of the total market value, whereas by 2023, this figure had risen to 5.5%, with an average growth rate of 3.3%. This indicates a growing reliance on earnouts as a mechanism in transactions. As noted in the Wall Street Journal, “Earnouts are on the rise in mergers and acquisitions as companies look to close the gap between what buyers want to pay for a deal and what sellers think they are worth.”13 Despite fluctuations in the total market value, including declines in certain years such as 2023, the value and proportion of earnouts have shown a consistent upward trend, underscoring their growing importance in the market.
As previously mentioned, S&P data indicates a significant presence of transactions in the healthcare sector, with consistently higher values compared to other industries. LSEG data corroborates this observation. As shown in the table below, healthcare consistently exhibits higher total earnout values compared to industrials and real estate. Additionally, the sector has a relatively high number of deals, indicating robust activity.
The healthcare sector’s percentage of the total market has generally been substantial, indicating its importance and consistent performance. There was a significant increase in the healthcare sector’s market share in 2022 (39.1%) compared to the previous year (23.8% in 2021). The sector’s lowest share was in 2017 (15.7%), suggesting a period of relative underperformance or market shift.
M&A League Tables
M&A Advisory League Tables are publications that rank the top financial advisors in the field of mergers and acquisitions. These rankings are based on various factors such as the types of deals the advisors have handled, the regions they operate in and the industry sectors they specialize in. This provides a comprehensive overview of the best performing advisors in the M&A field based on deal value and volume of transactions. The purpose is to generate an accurate ranking of the top financial advisors on the street, where deals are ranked and accurately reflected based on the cost to the acquirer of the transaction from an enterprise value perspective.
The below league tables represent the FY 2023 deals with earnouts in healthcare, with a particular focus on the healthcare sector due to its large share consideration in relation to the total market. The left-hand column shows the ranking of the advisors and deal value for the aforementioned transactions, and the right-hand side of the table is discounting the aggregated value of earnouts for each related advisor.
Note: Values in USDm as of December 2023 (LSEG – deal data)
Effects of Earnouts on League Tables and Deal Values
Earnouts, a popular method of structuring M&A deals, have been a subject of debate in the context of M&A valuation and league table rankings. These contractual provisions introduce a level of complexity and potential dispute into the transaction value. While they can be beneficial for both buyer and seller, their inclusion in the transaction value can potentially skew the benchmark, leading to an inflated view in the M&A landscape. This discrepancy can cause large differences in league table rankings, creating significant gaps between results from a volume and value perspective. Therefore, it is crucial to critically examine the role of earnouts in M&A valuation and consider the potential benefits of excluding them from league table calculations. This would ensure a more accurate assessment of the value and impact of M&A transactions.
The inclusion of earnouts in M&A transaction values is a topic of considerable debate, particularly when it comes to league table rankings and the accurate assessment of transaction impact. Both LSEG and Mergermarket have their own methodologies for incorporating these future payments, leading to potential disparities in reported transaction values and rankings. LSEG includes future payments such as earnouts and contingent value rights in the transaction value, assuming that all performance goals will be met and crediting the transaction with the full payment. This approach does not actively seek out whether the targets are eventually met, potentially inflating the transaction value and skewing league table rankings. On the other hand, Mergermarket includes earnouts or future additional payments in the transaction value only if the time horizon of the earnout is within two years of the completion of the transaction. This more conservative approach limits the inclusion of uncertain future payments to a shorter timeframe, potentially providing a more realistic view of the transaction’s immediate financial impact.
The disparity between these methodologies can lead to significant differences in league table rankings and the perceived value of M&A transactions. LSEG’s approach may result in higher reported transaction values, creating an inflated view of the M&A landscape. In contrast, Mergermarket’s method may offer a more tempered and potentially more accurate reflection of transaction values by limiting the inclusion of uncertain future payments. This discrepancy underscores the importance of critically examining the role of earnouts in M&A valuation and considering the potential benefits of standardizing their inclusion criteria. A more consistent approach across different platforms would ensure a more accurate and comparable assessment of the value and impact of M&A transactions, ultimately leading to more reliable league table rankings.
The data below shows that earnouts have a significant impact on overall deal values. The total deal value including earnouts is $251.1bn, whereas the total deal value excluding earnouts is $171.6bn. This indicates that earnouts contribute approximately 31.7% of the total deal value. The data also shows variations in the earnout amounts across different years. While the deal values fluctuate, the earnout amounts remain relatively consistent, ranging from $11.1bn to $17.1bn. This suggests that earnouts are a common feature in M&A deals.
Note: Values in USDm as of May 2024 (LSEG – deal data)
Disparity has been highlighted in recent business transactions, such as the global development and commercialization collaboration between Daiichi Sankyo and Merck, AstraZeneca’s acquisition of Eccogene and Roche’s partnership with Alnylam. In these cases, the final transaction value is influenced by the added complexity of earnouts or contingent values agreed upon as part of the deals.
Note: Values in USDm
The table above provides information on three different deals:
- The first deal is between Daiichi and Merck, announced on Oct. 19, 2023. The deal value is $22bn, with an earnout of approximately $18bn and an upfront value of $4bn.14
- The second deal is between Alnylam and Roche, announced on Jul. 24, 2023. The deal value is $2.8bn, with an earnout of $2.49bn and an upfront value of $310m.15
- The third deal is between Eccogene and AstraZeneca, announced on Nov. 10, 2023. The deal value is $2bn, with an earnout of $1.815bn and an upfront value of $185m.16
These examples support the fact that earnouts generate an inflated deal value, which does not accurately reflect the actual cost to the acquirer at the time of the acquisition.
For instance, in the acquisition of Carmot by Roche,17 the acquirer gains access to Carmot’s R&D portfolio, including clinical and pre-clinical assets, as well as exclusive access to Carmot’s innovative Chemotype Evolution discovery platform in metabolism. This acquisition strengthens Roche’s R&D efforts and portfolio in cardiovascular and metabolic diseases. Financially, Roche has acquired all outstanding shares and options of Carmot at a purchase price of $2.7 billion. Additionally, Carmot’s equity holders may receive payments of up to $400 million based on the achievement of certain milestones.
The value reflected in databases is $3.1 billion, which includes the potential earnout payments. This practice inflates the reported deal value, as it does not accurately represent the immediate cost to the acquirer. Furthermore, league table agencies often do not follow up on whether these earnout milestones have been met, leading to a cumulative inflation of overall transaction values.
Note: Values in USDm
Our Perspective
Including earnouts in deal valuations can lead to an inflated view of the M&A landscape, creating gaps between results from a value perspective. This discrepancy can distort league table rankings and misrepresent the true value and impact of M&A transactions, which is supposed to be the cost to the acquirer at the time of acquisition. To ensure a more accurate assessment of the value and impact of M&A transactions, it is recommended to exclude earnouts from league table calculations. This would provide a clearer and more transparent representation of the actual cost to the acquirer at the time of announcement and avoid potential distortions in league table rankings. There is a need for a standardized approach to reporting earnouts across different platforms and databases. This would help ensure consistency and comparability in M&A transaction data. Additionally, providing specific examples or case studies where the inclusion of earnouts significantly distorted the perceived value of a transaction can help illustrate the practical implications of the issue.
Based on the analysis of the effects of earnouts on league table rankings in the M&A landscape, we support the exclusion of earnouts from deal valuations. While earnouts offer benefits such as providing flexibility in deal structures, mitigating risks for both buyers and sellers, and bridging gaps in valuation expectations, they also introduce complexities and uncertainties from a valuation standpoint. Since earnouts are contingent payments that depend on the future performance of the acquired business, the inherent unpredictability of future business performance introduces uncertainty into earnout agreements, posing a challenge in accurately estimating potential payouts.
