Why Earnouts Matter
Acquisitions involve risk. No matter how confident the owner of a business is in its future prospects, no matter how optimistic the pitch from the investment bankers, no acquisition is risk-free for the buyer. In fact, research suggests that the majority of them fail.
Not all of them of course. Many a fortune has been built through smart acquisitions and there are countless examples of successful M&A, at both a large and small scale.
Interest in buy-side M&A continues to grow, with many seeing “entrepreneurship through acquisition” as the preferred alternative to a startup, or a corporate career. The growing search fund ecosystem is populated by thousands of young MBAs who would prefer to acquire a business of their own than stay in a safe job at a large corporation.
They have no shortage of acquisition targets. As much of the wealth in the western world is owned by “Baby Boomers”, it is anticipated that the next couple of decades will be characterised by a large transfer of this wealth to the next generation. Small businesses will be part of this – it is estimated that as many as 8 million businesses owned by Boomers in the United States alone will need to be sold, handed down or closed as their owners look to retire.
And yet most of these businesses don’t actually sell. It is commonly understood in the industry that of all of the businesses listed for sale with business brokers or on platforms like BizBuySell, around 90% of them never find a buyer. For buyers the situation is equally frustrating. Many buyers spend years looking for the right acquisition and trying to close a deal. Corporate and private equity buyers review far more acquisition opportunities than they actually close. Even in the world of search funds, where the raison d'être is to find a single business to acquire and the founder is a paid to search full-time for one, more than one third (37%) do not find a suitable target within 24 months, according to Stanford University’s 2024 Search Fund Study.
Part of the disconnect between the owners of these businesses and their potential acquirers is the “valuation gap” – the difference in valuation expectations between buyer and seller. Earnouts and other deferred consideration instruments have long been seen as a way to bridge valuation gaps: by reducing risk for the buyer, they enable him or her to pay a higher price.
Trust Issues
But earnouts, seller’s notes and other forms of deferred consideration suffer from trust issues. Sellers simply prefer cash. It doesn’t help that stories abound of sellers not achieving earnouts due to mismanagement of the business post-acquisition, or – even worse – not being paid deferred consideration when it is due.
No Standards
Much of the problem lies in the fact that there is no standard approach to managing earnouts: no accepted standard for sharing data post-acquisition, nor a standardised platform for doing so. There is also a general naivety among sellers regarding how difficult it is for acquirers to integrate acquisitions smoothly and continue to grow them post-closing (partly due to optimistic pitches on behalf of both buyers and intermediaries). Sellers often expect every aspect of the management of the business to improve, or at least not decline, after acquisition by a larger company.
The immediate post-closing period is challenging for acquirers, who prefer not to have external oversight while attempting to “land the plane”. So buyers typically provide little information to sellers, who are blissfully unaware that all is not well. We will explore this in a future post.
Another concern for sellers is the risk that a seller’s note, or an earnout that is earned, will not be paid, as in the case where the buyer runs into financial difficulty, or simply chooses not to pay.
The upshot of this is the current state of affairs in M&A: frequent poor performance during earnout periods, a lack of transparency for sellers and a general lack of trust in deferred consideration.
Not that buyer fraud is very common. But mismanagement (or less than optimal management) of the business during the earnout period is far too common.
A Better Way
If all of this was handled better and sellers had more confidence that their earnouts would be (i) earned and (ii) paid, valuation gaps on many more deals could be closed using these devices. Sellers would have more trust in the deferred component of the consideration and more deals would close as a result.
With more trust in earnouts and seller financing, these instruments would not only be used more frequently but buyers would be able to structure deals with a larger proportion of deferred consideration, enabling some businesses to sell that would otherwise be considered unsaleable, by reducing risk for the buyer while giving sufficient confidence to the seller.
The Future
This is the future that earnout.com will make possible. Sellers using earnout.com will be far more likely to achieve their earnouts. With added protections for sellers, they will also have more confidence in getting paid when their seller’s notes or earnouts are due. Buyers who use the earnout.com platform will give more confidence to prospective sellers and will close more deals using deferred consideration as a result.
Earnouts are the answer to the valuation gap problem. With a better system in place for managing them, a greater number of buyers will be able to use these instruments to make attractive offers and close more deals, while more business owners will be able to find willing buyers for the businesses they have spent years building.