The Earnout

What is an earnout?

In French, the expression that comes closest to it is “conditional price supplement”. THEEarnout thus combines two key concepts:

• It is a part of the sale price that is paid not at the time of signing, but at a later date.
• The amount of this additional price depends on the fulfilment of certain conditions.

There are two fundamental reasons for setting up a Earnout :

1. The first comes from the difference in the appreciation of the seller and the buyer about the intrinsic value of the company. In other words, the seller thinks that his startup is worth significantly more than what the buyer is willing to pay. In order to bring the points of view closer together, both parties agree that part of the price will be conditioned on the future performance of the company. This reduces the buyer's risk, while allowing the seller to capture all the value if the performance is good. From this point of view, theEarnout Is a compromise.
2. The second reason is to make it a motivational tool for the founders of the start-up being purchased. In order to ensure that after the transaction, the team always wants to give as much as possible, the parties agree on goals whose achievement triggers additional financial rewards. From this point of view, theEarnout Is a carrot.

Is earnout a frequent practice?

Out of all Galion start-up releases analyzed, three-quarters of the deals contained a Earnout. It is therefore a tool that is widely used in transactions.

Intuition suggests that theEarnout should be particularly relevant for small transactions involving start-ups with an economic model that is still uncertain. For more mature companies, it can be assumed that the buyer will have better visibility on the future. In this case, the use of a Earnout is less justified. In practice, it can be seen that there is no correlation between the amount of the transaction and the presence or absence of a Earnout. This is explained by the fact that a mature start-up generates much higher expectations and therefore that the valuation gap between the buyer and the seller is still there.

For Galleons who buy other start-ups (start-ups often buy each other out), theEarnout only concerns two thirds of transactions. This can be explained in two ways:

• These are generally companies in the same sector that often know each other well, so assessing value is easier. On the other hand, the less familiar a company is with the activity of the start-up it is buying, the more it will tend to see in theEarnout a kind of insurance against a poor initial valuation. In this regard, it is interesting to note that European manufacturers are much more interested inEarnout than American technology groups, the latter generally having a better ability to assess the strategic contribution of the acquisition.
• The vast majority of the transaction between startups is in unlisted shares, the spirit of which may be more like a merger than a formal takeover. All the parts are aligned to value the new set, there is no real need to add an additional motivation mechanism.

Earnout, a device primarily intended for founders

THEEarnout, which is a component of the selling price, should in principle be intended for all shareholders. In practice, this is far from always the case. Investors are in fact not concerned with theEarnout only in a quarter of transactions, the rest being reserved mainly for founders and more rarely for employees. This major trend can be explained by 3 reasons:

• Ensuring the post-transaction motivation of the operational team is at least as important as the risk-sharing aspect of the price.
• in general, venture capitalists try as much as possible to avoidEarnout (even if it means touching a little less), because they know that they will have no control over it (unlike the founders). It is only for startups in difficult situations that they agree to enter the game. In these cases, as their investment has often already been written off in their books, the risk associated withEarnout is no longer so much of a problem.
• When he can, the purchaser will always seek to privilege his relationship with the founders rather than with the financial investors who, from his point of view, do not contribute anything to the future of the start-up. Moreover, this dynamic can create significant tension if the conditions offered to operational staff are clearly unbalanced compared to those offered to financial investors.

When the founders are the only beneficiaries ofEarnout, this is generally conditioned not only on performance, but also on maintaining the founders in their operational function within the start-up. This makes it possible to combine risk sharing, motivation and talent retention.

When a start-up buys another start-up, theEarnout is almost always meant only for founders. We can see that, in this case, the personal relationship between founders is a key element of the transaction.

What is the earnout amount?

The amount ofEarnout compared to the total price of the transaction varies considerably from one deal to another. On the Galion start-ups analyzed, this is broken down as follows:

When a start-up from the Galion panel buys another start-up, theEarnout also tends to be less significant and almost never exceeds half of the total price.

Plus the weight ofEarnout is important in a transaction, the more it tends to be focused on the only founders who have better control of the associated risk than financial investors. In parallel, we note that the weight ofEarnout in relation to the total price tends to decrease with the size of the transaction. In fact, the greater the financial stakes, the more the seller wants to limit the volatility on his exit price.

The right length of time for an earnout?

Duration is of course a very sensitive subject for all parties. At first glance, sellers should aspire to a Earnout as short as possible, while the purchaser follows the opposite logic. In reality, it's not that easy. After the transaction, there is a phase of integration into the buyer's organization: this process is often quite destabilizing for a start-up that is used to operating completely independently. The adjustment can therefore take some time before everyone finds their bearings. In fact, a Earnout Too short greatly increases the risk of missing the goals set. This is why in the majority of cases, we see that the parties opt for a Earnout lasting at least 3 years:

The size of the deal has a strong influence on the duration of theEarnout. The very short one-year earnouts were all applied to transactions of less than 20 million euros. On the other hand, for earnouts that last 4 years and more, there is a very strong over-representation of releases at more than 100 million euros.

On what basis should earnout be calculated?

There are multiple ways to calculate a Earnout. In the majority of cases, parties try to focus on one or two key financial indicators:

Unsurprisingly, profitability is the most used indicator. From the seller's point of view, this is the data that in fact gives the most flexibility: it can be achieved either by increasing turnover more quickly than costs, or by simply rigorously controlling expenses. From the perspective of the purchaser, this is the most natural indicator, since in the long term, any acquisition is expected to contribute to increasing the profits of the buying group. However, this profitability indicator can generate some perverse effects. A team that is too focused on a short-term profitability objective may in fact choose to deliberately underinvest, at the expense of future growth.

This is the reason why turnover growth is preferred in a good quarter of transactions. The volume of business is, in general, what has the most strategic value for the purchaser. That said, if he chooses this data, the purchaser will have to ensure rigorous cost control on the start-up to avoid the classic explosion of expenses aimed only at inflating the business in a non-sustainable way.

The combination of turnover and profitability may seem like the ideal compromise, but be careful not to complicate the calculation too much, at the risk of losing readability. The use of non-financial indicators is quite rare and concerns almost exclusively start-ups in the early stages.

How is the earnout amount determined?

Once the performance indicator is selected, two approaches to calculate theEarnout stand out:

• The provisional business plan: the buyer and the seller agree on a provisional business plan with a target turnover or net result. If the objective agreed at the beginning is achieved, theEarnout is paid.
• The mathematical formula: The amount ofEarnout results from a simple calculation formula, typically a multiple of turnover or net income.

Of course, each approach has its pros and cons. To justify the transaction to its own shareholders, an industrial buyer must draw up a provisional business plan that is as rigorous as possible. So, it seems quite healthy to align the purchased team with its own strategic goals. The message is clear: if the objective is not reached, theEarnout is not paid. On the other hand, if the planned objective is exceeded, it is entirely possible to provide an additional incentive, which is also observed in 30% of the deals analyzed in this study.

The main obstacle is that if, along the way, the provisional plan becomes out of reach, this can demotivate the founders, which is counterproductive for the purchaser. To overcome this, there are various mechanisms: partial payment on a partial objective, payment by instalments or even the possibility of deferring an objective that has not been reached. These various provisions can quickly make the clauses ofEarnout very complex, which is in no one's interest... except of course the lawyers who write them!

In contrast, the mathematical formula has the great merit of being extremely simple. It is particularly attractive for a buyer who does not have a good appreciation of the real potential of the business he is buying. Based on a financial ratio that it controls, it also makes the transaction easier for its shareholders to understand. The problem is that we can find ourselves in configurations where, despite unachieved strategic objectives, the purchaser is obliged to pay a Earnout very significant to sellers. In other words, by reducing the volatility ofEarnout In case things don't go as well as expected, the mathematical formula tends to be more favorable to sellers. In case of great business success, one of the additional attractions of the mathematical formula for sellers is that, in principle, there is no limit to the amount ofEarnout. In practice, in almost half of the cases studied, the purchaser nevertheless ensured security by stipulating a maximum ceiling on the formula.

Overall, both methods are used equally, but there are some factors that have an important influence on the choice. For example, we note that for deals where the challenge ofEarnout is relatively weak, the predictive business plan method is largely dominant. On the other hand, when theEarnout represents an important part of the total price, the mathematical formula becomes the majority method. This is quite logical, since for deals where theEarnout is an essential element in the remuneration of sellers, it is natural for them to limit their risk by ensuring that they receive a significant amount, even if the strategic objectives of the deal are not achieved.

The duration ofEarnout affects the method chosen. For short earnouts (up to 2 years), the provisional business plan is almost always preferred. On the contrary, for a Earnout long (4 years and more), for which financial forecasts become really risky, it is naturally the mathematical formula that becomes the arch-dominant tool.

For the start-ups on the Galion panel that buy other start-ups, the weight ofEarnout is generally less important than in the case of an industrial purchaser, and is carried out over a shorter period of time. The business plan method is therefore widely preferred.

What tax regime for earnout?

For the founders, the great interest ofEarnout (compared to a simple deferred payment) is that it falls under the favorable tax regime for capital gains. For the purchaser, theEarnout is the joy of CFOs because, unlike traditional employee loyalty tools, it has the advantage of not impacting EBITDA.

To prevent the tax authorities from requalifying theEarnout in salary earnings (which she has tried to do many times in the past given the important issues), you must ensure that the calculation of theEarnout be directly correlated to the startup's activity, and especially that it is never guaranteed or certain. In this, theEarnout is always more than just an additional price. If, as is often the case, theEarnout is subject to the presence of the founders in the company, it is necessary to be particularly rigorous about the random nature of theEarnout. To reinforce the solidity of the arrangement, the trend is to sell by installments. However, this approach can put off American buyers who, in general, like to be able to consolidate 100% of the startup acquired in the wake of the transaction.

Is Earnout still well paid?

So much for the theory, but you still have to ask yourself the question of whether theEarnout is a mirror to the larks or is ultimately transformed into real money. In this regard, there is a significant difference of appreciation on both sides of the Atlantic. Americans assume that a Earnout is almost always paid in full, even if the performances are not up to date. In the latter case, they expect a legal dispute that will most often end in a transaction. Europeans, who have a less legal culture, expect theEarnout be paid only in case of real achievement of the objectives. As a precaution, European venture capitalists almost always valueEarnout to zero in their books, until they actually touch something.

In practice, it seems that Europeans have the right instinct to be cautious because, on the sample observed,Earnout was paid in full only in less than 40% of cases, which is quite consistent with the success rate of industrial acquisitions. In the sample observed, this full payment ratio is not correlated with either the size or the duration of theEarnout.

On the other hand, the situation changes radically if the buyer is not an industrialist but a startup from the Galion panel. In this case, theEarnout is paid in full in 90% of cases. This dramatic difference can be explained by the fact that, since the motivation of the purchased founders is a key element in the success of the transaction, the parties most often demonstrate flexibility in objectives, so that a Earnout improperly calibrated at the beginning does not damage the relationship.

To maximize the probability of success, it is also crucial to clearly clarify post-acquisition governance. For the purchased founders to really have control of their destiny, the startup must maintain a certain degree of management independence. At the same time, this independence is in contradiction with the desire of the purchaser to make use of the synergies between its historical activities and those of the startup being purchased. If poorly anticipated, these contradictory goals quickly lead to a lot of tension in the relationship. It is of course all the more complicated because theEarnout extends over a long period of time.

So is earnout a good thing?

At first glance, theEarnout seems to be a necessary evil that is massively suffered by sellers who do not have enough bargaining power to require full cash payment at the signing of the transaction. But we can also design theEarnout as a powerful tool, which allows a potential buyer to have the necessary comfort to complete a transaction. In this regard, it is symptomatic that almost half of the earnouts are established not at the time of the term sheet, but after due diligence during the final negotiation. In these cases, theEarnout is most often the key that allows all parties to cross the finish line.

Certainly, theEarnout introduces for the seller an element of uncertainty about the exit price that can be very significant. But theEarnout can offer something even more important: the certainty of having an exit, a privilege that we often forget concerns barely 20% of funded startups.

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