Closing the Value Gap: Examining the Utility of Earnout Provisions in M&A Transactions

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With so many ways to value a business, such as the asset-based method, a discounted cash flow analysis or the market method, it is no surprise that business valuation has been described as more of an art than a science. This complexity is particularly true when a material portion of the value of a business is based on the seller and buyer’s competing perspectives regarding the future performance of the business following its prospective sale. Like in the United States and other non-Canadian jurisdictions, one of the common ways in which sellers and buyers of Canadian businesses and their advisors often bridge this value gap is through the use of an earnout provision.^[1]

An earnout provision typically states that part of what may ultimately be paid to a seller for their business will be calculated based on the ability of the business to achieve certain metrics within a specified period of time following closing.

This article examines trends in the use of earnout provisions, the elements of typical earnout provisions, different forms of earnout structures and key points for sellers and buyers to be aware of when considering whether an earnout provision is suitable for their transaction.

Trends Regarding the Use of Earnout Provisions in Canada and the U.S.

The use of earnout provisions in Canada in the private share purchase context has been on the rise in recent years. According to Thomson Reuters’ “What’s Market: Earn Outs” deal point study, published in November 2023 (“What’s Market: Earn Outs”), earnout provisions appeared in roughly 28% of private acquisitions in Canada, slightly down from the highest rate surveyed by the study in the past five years at 33% for the year prior.^[2] While a 5% decline may not appear noteworthy, the figure reflects a substantial decrease of 20% in the use of earnout provisions in private asset purchase agreements (from 37% in 2021 to 17% in 2022) and a slight increase in the prevalence of earnout provisions in share purchase agreements (from 31% in 2021 to 35% in 2022).^[3] Further, one of Canada’s key industries – mining and metals – had the highest proportion of earnouts, with 46% of all private mining and metals deals from 2020 to 2022 including an earnout provision, followed closely by deals in the services industry at 38%, and deals in the pharmaceuticals and biotechnology industry at 35%.^[4]

Although there can be differences between M&A practice in Canada and the U.S.,^[5] the use of earnouts in the U.S. has generally mirrored their use in Canada. While the American Bar Association’s (“ABA”) 2021 Private M&A Deal Points Study showed that roughly 20% of private M&A transactions in the U.S. contained earnout clauses – the lowest percentage surveyed by the ABA in more than five years and a figure that had dropped dramatically from a high of 27%, according to the ABA’s earlier study in 2019 – the ABA’s most recent study demonstrates that the use of earnout provisions has rebounded in the U.S.^[6] According to the ABA’s 2023 Private Target M&A Deal Points Study released in December 2023, the use of earnout provisions is on the rise, increasing to a prevalence of 26% in the most recent sample of American private transactions reviewed by the ABA.^[7]

Components of an Earnout Provision

Most earnout provisions will include:

• one or more specific metrics that are used to measure whether a specified target is hit;
• the timeline by which certain target(s) must be met in order to trigger the payment associated with the earnout provision; and
• details concerning the form of the earnout payment, including the amount that will be paid if the specified target is met within the required timeline.

According to What’s Market: Earn Outs, the most common metric in Canada used to measure whether an earnout target is met is revenue of an acquired company post-closing, with 43% of private deals relying on revenue as the main earnout metric.^[8] Behind revenue are metrics like EBITDA (earnings before interest, tax, depreciation and amortization) and royalty mechanisms, appearing in 10% and 14% of deals reviewed, respectively. Less relevant metrics include regulatory approvals and commodity prices. While using a single metric is common, complex transactions may rely on multiple metrics to determine whether the targets set out in the earnout provision have been achieved.^[9]

The term during which the target of an earnout provision must be met in M&A transactions involving Canadian businesses typically ranges from 12 to 36 months. However, the timeline for any target is largely dependent on the nature of the metrics measuring whether the target is achieved. Certain metrics, such as the receipt of impending regulatory approval, are fixed and can lead to relatively short deadlines, whereas metrics that are long-term or enduring, such as royalty streams, may suggest that an indefinite timeline is appropriate.^[10]

Most earnout provisions set out exactly what the stated earnout payment will be or what the formula to calculate the amount will be if the target of the earnout is met. Earnout provisions can also include language which modifies the base earnout amount or limits it, such as a required minimum and/or a stated maximum payment. In each such case, a seller may seek to negotiate that the buyer place some portion of the earnout amount into escrow. Holding the minimum amount in escrow can provide a seller with comfort that at least a portion of the earnout amount will be available for release and able to be paid by the buyer if the earnout target is indeed met. Earnouts can be paid in cash, securities or other property, or a combination of both. However, satisfying an earnout payment with securities may trigger certain disclosure and regulatory commitments and can further complicate the valuation process.

Earnout provisions can also feature corporate governance covenants in favour of sellers that can require a buyer to operate the purchased business as a standalone entity, forcing the buyer to operate the target consistent with past practice and/or in some other fashion that maximizes the potential earnout for the seller. Another “seller-friendly” covenant that can be included in M&A transactions is an acceleration clause. An acceleration clause largely benefits sellers by creating a mechanism through which sellers can receive earnout amounts from the buyer before the target of the earnout is reached, such as where a buyer breaches operational covenants included in the purchase agreement or terminates certain key employees of the business without cause.^[11] In recent years, Canada has seen a decline of earnouts accompanied by seller-friendly covenants with only 19% of deals that feature earnouts including them, according to What’s Market: Earn Outs, down from 22% two years prior.^[12]

Different Earnout Structures

While earnout provisions can be structured in a variety of ways, some of the more common structures for earnouts include the following:

• Classic Earnout: In this structure, a certain portion of the purchase price is not paid at closing and is only payable to the sellers if a specific target is achieved (typically measured using financial metrics) by a certain date. A typical such provision in a share purchase agreement could require a buyer to pay the sellers an additional cash payment if the target company subject to the agreement (the “Target Company”) achieves a certain EBITDA target by a specified date.

  
  Example of a Classic Earnout: Sellers sell all of the shares of the Target Company to a third-party buyer for initial cash consideration of $20 million, with an earnout provision providing that in the event the Target Company achieves: (i) $5 million of 12-month trailing EBITDA one year from closing, the sellers will be entitled to receive a cash payment of $1 million; and (ii) $10 million of 12-month trailing EBITDA one year from closing, the sellers will be entitled to receive a cash payment of $2 million. In this example, if neither of the one-year EBIDTA targets are met within the one-year post-closing period, then the sellers would not be entitled to any earnout payments.

• Staggered Earnout: In this structure, a certain portion of the purchase price is not paid at closing and is only payable to the sellers if certain targets are met (typically measured using financial metrics) at different points of time over a specified post-closing period. A staggered earnout is different than a classic earnout in that the sellers can be entitled to one or more additional cash payments post-closing if the Target Company achieves multiple different targets over an extended period.

  
  Example of a Staggered Earnout: Sellers sell all of the shares of the Target Company to the buyer for initial cash consideration of $20 million, with an earnout provision providing that, in the event the Target Company achieves: (i) $5 million of 12-month trailing EBITDA one year from closing, the sellers will be entitled to receive a cash payment of $1 million; and (ii) $10 of million 24-month trailing EBITDA two years from closing, the sellers will be entitled to receive an additional cash payment of $2 million. In this example, if the first target is missed, then the sellers would no longer be entitled to that payment, but they would still receive the second earnout payment if the second target was met. If both targets are met, then the sellers would be entitled to both earnout payments.

• Earnout With Redemption or Conversion Features: This type of earnout can be used in transactions where securities of the buyer, or an affiliate thereof, form a portion of the purchase price. In this structure, earnout mechanisms can be built into the purchase price calculation to either reward sellers for the achievement of certain targets post-closing or penalize them for the failure to achieve those targets, and typically involves the initial issuance of a new class of non-voting preferred shares (“Consideration Shares”) of the buyer to the sellers at closing. Such shares can either be converted into common shares (“Buyer Shares”) or other voting securities of the buyer, or redeemed and cancelled for nominal consideration.
  
  Example of an Earnout With Redemption/Conversion Features: Sellers sell all of the shares of the Target Company to the buyer for initial cash consideration of $20 million, comprised of $15 million of cash and $5 million of Consideration Shares, calculated based on the value of such shares upon conversion into Buyer Shares if one or more targets are met (based on the enterprise value of the buyer, including the Target Company as its subsidiary). The target (or targets) triggering the earnout can be similar to those described for a classic or staggered earnout. If there is only one target triggering the earnout (such as in the case of a classic earnout), then upon the achievement of such target, all of the Consideration Shares would automatically convert into Buyer Shares. But where the target is not met, then all of the Consideration Shares would automatically be redeemed for nominal consideration and cancelled, effectively reducing the purchase price by $5 million.

Earnout Considerations for Sellers and Buyers

In addition to the components and structures of earnouts described above, the following are additional key considerations that sellers and buyers should keep in mind when deciding whether to include earnout provisions in their M&A agreements:

• Earnouts can be useful tools, allowing parties to a transaction to bridge the gap during the valuation of the business and discussions on purchase price. Understanding the potential risk as a seller is important when agreeing to the inclusion of an earnout in an M&A transaction. Regardless of the dollar amount of the earnout agreed to by the seller and the buyer upon the earnout targets being met, there is always a risk that the purchase price received will be less than expected if the earnout target is not met. And even if the target is met, there can be risk that the buyer no longer has the financial or other means to pay the earnout amount. The use of an escrow arrangement can help alleviate a portion of this latter risk.
  
• If an earnout provision is agreed to, both an understanding of the business expectations around the earnout and the drafting of the purchase agreement should be clear and concise. This includes accounting for potential changes to the business itself, such as shared usage of assets, new products or service offerings introduced after closing, and post-closing acquisitions. Detailing how these events will be treated is important to avoid unnecessary exposure to risk for the seller and buyer alike. A model calculation included as an exhibit or schedule to the purchase agreement could assist in clarifying the expectations of the parties.
  
• The use of earnout provisions in M&A transactions is increasing in the U.S. and Canada, but the covenants protecting sellers that would normally insulate them from the risks associated with earnouts are becoming less popular. Sellers would be wise to negotiate by including corporate governance covenants or acceleration clauses for protection from the risk that a buyer fails to take the metrics and targets stated in the earnout provision seriously. Buyers must equally be cautious on matters of corporate governance and acceleration to avoid overly limiting their ability to operate and manage the business going forward.^[13]

Conclusion

An earnout can eliminate potentially contentious up-front valuation negotiations by having each party “put its money where its mouth is” by effectively betting that its value position is correct, with the actual performance of the business over time being the ultimate arbitrator of the value of the business. However, both sellers and buyers should always be fully aware of the relevant metrics, targets, timelines and associated risks when considering the use of earnout provisions in their purchase agreements.

The Capital Markets Group at Aird & Berlis LLP will continue to monitor matters related to earnout provisions in M&A transactions. If you are a business owner or a potential buyer considering the use an earnout in an M&A context or have any questions on how to best navigate the use of an earnout provision in the sale or purchase of a business, please contact the authors or a member of the group.

[1] This article focuses primarily on the different considerations to be taken into account when determining whether one or more earnout provisions may be appropriate in the context of a private M&A transaction.