An earn-out is a form of contingent consideration payable to the seller based on the performance of the target for a period of time after the closing of a M&A transaction. Earn-outs are typically structured as one or more payments made upon the achievement of certain specified milestones.
Earnouts generally are pegged of financial metrics such as EBITDA, Gross Profit or Revenue/Sales. At times they are pegged to operational metrics, i.e. entering a new market, managing the mix of revenue by customer or channel, regulatory approval of a new drug (biotech)
Earn-out periods typically range from 12 to 36 months, with one payment made at the end for earnouts of shorter duration and multiple payments made at the end of each year for multi-year earn-out periods.
The use of earnouts has increased in the last few years, with more than a third of M&A transactions incorporating it.
Which one(s) are a better gauge, financial or operational (metrics)?
From the cases I came across, Ebitda, as well as revenue targets are almost always stipulated. Operational covenants are also often included.
Payment terms. The payment to be received by the seller upon achievement of the earn-out target is generally structured as (i) a flat fee, (ii) a multiple of the amount by which the business exceeds the earn-out target or (iii) a percentage of the earn-out target. For example, if the overall purchase price for the business was determined based on a specific multiple of the business’s EBITDA, then it may be appropriate to tie the earn-out to EBITDA and the payment to be a multiple of the overall amount by which the business exceeded the specified target. Parties often specify a maximum amount payable, or a cap, in the event that the business far exceeds the earn-out target. (Source: Use of earn-outs in private M&A transactions, Stuart Welburn and Corby J. Baumann)
Covenants
Post-closing covenants may require (i) that the buyer maintain separate books and records for the business
(ii) that the buyer dedicate a certain minimum level of working capital to maintaining the business (in other words not sucking dry the bank)
(iii) that the buyer not engage in any change of control or sale transaction involving the business (keeping the management) or
(iv) that the buyer maintain a certain level of effort in operating the business (such as commercially reasonable efforts) in order to reach the earnout targets.
The tax treatment of the earnout may vary, including the recognition, timing and characterization of the seller’s taxable income generated and should be carefully considered.
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Acceleration; buy-out option. In structuring an earn-out, the seller and buyer need to agree on whether any actions will result in the acceleration of all or any portion of the earn-out. For example, the sale of the target business during the earn-out period or the termination of key executive officers may result in all or some portion of the remaining earn-out payments becoming immediately due and payable. Acceleration gives the seller some assurance that the buyer may not take certain specified actions that could adversely impact the performance of the business and/or the ability to make the earn-out payments when they are due.
Alternatively, the buyer may request a buy-out option allowing the payment of a specified amount to satisfy any remaining requirements under the earn-out and releasing the buyer from its ongoing obligations relating to the earn-out and any post-closing covenants applicable to the business. (Use of earn-outs in private M&A transactions, Stuart Welburn and Corby J. Baumann)
If interested in delving further, I recommend reading SSR‘s primer on Earnouts which explains the limitations of the DCF analysis and why Probability-Weighted Expected Return Method, Monte-Carlo and Real Options/Black-Scholes are preferred.