Earnouts present an opportunity for BV practitioners

BVWireIssue #98-2
November 10, 2010

During the session “Merger & Acquisition Disputes: Addressing Earnout Issues and Assessing Damages” at the AICPA National BV conference Robert Gray (ParenteBeard) told the audience that in today’s recessionary climate, the private equity community is still struggling to lever deals.  Hence, earnouts remain a critical part of any deal negotiation, and Gray thinks there are untapped opportunities.

Earnouts appeal to buyers because they:

• Protect buyer from overpaying for the target business.
• Are effectively seller financing that reduces cash necessary at closing.
• Can distinguish buyer’s bid when multiple suitors are competing for target.
• Indicate sellers’ confidence.
• Provide motivation of seller management when seller management will continue to be involved in business post-closing.

Earnouts appeal to sellers because they:

• Protect seller from failing to realize value in their business.
• May allow sellers to obtain greater consideration that they might receive otherwise.
• Can be advantageous in difficult economic climates (such as today).
• May allow seller to control its own destiny when seller management will continue to be involved in business post-closing. 

However, “earnouts are a difficult area in M&A because it is hard to enforce and it is hard to take into account all of the contingencies,” said Jeff Litvak (FTI Consulting).Because of the current economic climate earnouts are here to stay,” he added.

Jeremy Kasner (Stout Risius Ross) continued the discussion of earnouts in the presentation Valuation of Contingent Consideration. “Despite the improving M&A markets, the valuation gap between buyers and sellers remains an obstacle in closing a deal,” Kasner told the audience. Earn-outs and clawbacks can help bridge the perceived valuation gap.” But financial reporting and measurement relating to contingent consideration can be complex and confusing. 

According to Kasner, issues to consider in contingent consideration valuations include:

  • Expected future cash flows “are consistent”. “You have to model in the factors that are driving the earnout,” he said.
  • The need to account for likelihood of hitting earn-out targets
  • Even “slam dunk” earn-outs must be adjusted for the time value of  money and credit risk. “There is still going to be credit related issues that have to be accounted for in the valuation”

The income approach is the most frequently employed approach, says Kasner.  “One of the good things about the income approach is that there are several methodologies you can use, such as DCF and Probability or Scenario-Based Methods. “Which one you use depends on the situation.”

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