September 17, 2020
Earnouts: Best Practices for Avoiding Disputes in the Covid-19 Era
We’ve seen a lot of insightful commentary on earnouts during the pandemic, and I’ve blogged about the topic quite a bit (here’s a recent one). The need to bridge valuation gaps is more pressing than ever in the current environment, so it’s not surprising that people are taking a hard look at earnouts & how to make them work better. This recent “Business Law Today” article is the latest article on earnouts to hit my inbox. Its focus is on best practices for designing earnouts with a view to minimizing the risk of disputes. This excerpt discusses how to select the right metric:
Determining the right earnout metric begins with an analysis of the methodology used by the buyer to value the target business, and whether that methodology is appropriate to measure the business during an earnout period. Three common ways to value target companies are:
– multiple of prior 12 months of EBITDA, which is used for companies with earnings (this is the most common valuation methodology);
– multiple of revenues, most commonly used for software and other technology companies that have been able to build significant sales but are not at the stage of having earnings; and
– a “build versus buy” analysis, in which the buyer assesses the cost to duplicate the functionality of the seller’s product or technology from scratch, versus the cost to buy the seller and its entire workforce (this measure is most commonly used for early-stage software and other technology companies prior to achieving significant sales revenues).
The article says that, in general, the valuation methodology used to value the business is the right starting point for discussions about the earnout metric. For example, if an EBIDTA or revenue multiple was used to value the business, then an increase in EBITDA or revenue is the logical place to begin when it comes to designing an earnout metric. But the article stresses the choice of the metric requires a much deeper analysis of both the value that the buyer is trying to create post-closing & its business plan to create this value.
– John Jenkins