Earnouts in Today's M&A Market: Bridging the Valuation Gap or Exploiting the Negotiation Gap?
Are earnouts in today’s M&A market still primarily serving to bridge the valuation gap between buyers and sellers? Or do we need a different explanation for the prevalence of earnouts in recent, large M&A deals? Buyers and sellers are negotiating in what is arguably the most uncertain economic climate of the past decade. Whereas in the past, the caricature of a cautious, risk averse buyer bargaining with an optimistic seller may have served as a useful – if crude – illustration of the buyer-seller valuation gap, it’s unlikely there are many Panglossian sellers out in today’s market. What is more, the idea that the valuation gap arises from a buyer’s superior knowledge about market and industry conditions doesn’t seem as plausible when applied to large deals between sophisticated players.
Earnouts have been a common term in acquisition agreements for high-growth businesses and small companies. By making part of the purchase price contingent on a target’s ability to meet future earnings targets or reach designated milestones, a buyer can reduce its exposure to the risk that the target doesn’t fulfill the seller’s rosy predictions. At the same time, a buyer can promise to reward the seller if the target’s post-sale performance equals the seller's projections of its pre-sale prospects. An earnout, the theory goes, enables wary buyers and eager sellers to bridge the gap between their respective valuations of the target’s future profitability.
What accounts for this disparity in valuations? Professor Brian Quinn quotes the abstract of a recent paper by Roberto Ragozzino and Jeffrey Reuer concluding that the use of earnouts “increases with information asymmetries surrounding mergers and acquisitions.” In their article, the authors argue that earnouts appear more often in acquisitions where the target is a new company or for other reasons doesn’t have access to the buyer’s superior market and industry knowledge. For acquisitions of small, private companies by buyout firms and strategic buyers like public corporations, Ragozzino’s and Reuer’s empirical findings make sense. But for this M&A season’s rash of earnouts, especially those appearing in large transactions, we may need to abandon our reliance on the explanatory power of a presumed valuation gap.
The cost of capital for buyout firms and other acquirers has risen considerably. On top of that, buyers are operating with an informational deficit. Even if they feel they may have a strong grasp of a target’s industry and confidence in its business model, the outlook for the general economy over the next 12 to 18 months is foggy at best. More important, unlike the M&A boom period of a few years ago, buyers do not have to push past as many elbows to bring a potential seller to the bargaining table. Buyers, that is, appear to have a negotiating advantage in today’s market. Earnouts help buyers negotiating with poor information under current economic conditions in two ways. First, it allows them to limit their financial exposure to new investments in the event the economy doesn’t revive in the short- to mid-term. Second, it allows them to defer a significant portion of the purchase price to a time when the cost of capital should be cheaper.
It’s true that earnouts in private equity deals have always served as a risk management tool. Yet, in the past earnouts generally served to protect buyers from a target’s failure to compete successfully in its industry, not from a continued or worsening recession. Now, however, private equity firms and other buyers are not merely hedging against business and industry-specific variables. They’re signing up for a broader insurance policy against future market conditions. The prevalence of earnouts in today’s market cannot be entirely attributable to a valuation gap; it would be wise to take a close look at the negotiation gap as well.
Related Posts:
