A key tool in dealmaking: the earn-out

An earn-out structure is a corporate finance tool that is critical when negotiating deals. Put simply, an earn-out adjusts the purchase price for a company based on the achievement of future financial milestones.

Technically, there can be non-financial milestones as well. I haven’t advised on such a deal myself, but I can easily imagine a situation in a venture capital scenario where the future payments are adjusted based on user growth rather than profitability, as those startups burn cash for years on end.

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As always, I use two things to explain a difficult concept: a recent example and a silly analogy.

On 17th June 2021, Imperial Logistics announced that it had entered into an agreement to acquire Deep Catch Namibia Holdings. The headlines would usually scream “Imperial acquires Deep Catch” but that’s not strictly true, as deals can (and do) still fall over after that stage.

An announcement like this is nothing more than an engagement party, to be honest. The companies still need to get married. In the due diligence process, the in-laws will be asked numerous difficult questions about the quality of their offspring.

For the sake of an earn-out analogy, the bride-to-be may ask her fiance’s mother about whether he cleans up after himself. Obviously, the mom will lie if necessary and say yes either way. The bride can accept that at face value, or may ask her for an earn-out agreement along the lines of: “If he doesn’t, you’re either taking him back or giving me some of your jewellery!”

It’s a deliberately ridiculous example because people don’t behave like that in their personal lives. In business though, it’s silly not to behave like that.

Information asymmetry

Nobody knows more about the groom than his parents. Nobody knows more about a company than the people who built it and are now selling it.

I can thus assure you that nobody knows more about Deep Catch’s business than the founders and management team of Deep Catch itself. Imperial can review financial statements and ask questions but cannot fully address the information asymmetry that is inherent in a process like this.

Imperial will learn about the business once it is the proud owner of it. It’s a bit like my current favourite investment saying on Twitter: “I do my best research when I’m down 20%!”

The only way to protect Imperial shareholders is to put in place a minimum earnings target for the current year, followed by an earn-out structure.

Initial earnings target

Once the engagement ring is on the finger, it’s easier to forget the importance of date night.

The same principle applies in corporate dealmaking. When a deal has been inked, the sellers often take their collective eye off the ball. That’s especially true when there is a full buyout, which is why I would never advise a 100% acquisition of a private company straight off the bat, unless it’s for a really great price.

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It’s different in listed companies that are taken private. They already have full executive management teams and structures in place, with appropriate incentives to ensure ongoing performance. That is almost never the case in private companies, which is partly why private companies trade at structurally lower valuation multiples than listed counterparts.

Nevertheless, Imperial bravely agreed to acquire 100% of Deep Catch, a private company that isn’t even in the same country. The risks of such a deal are substantial, so I wasn’t surprised to see an initial earnings target. This is similar to an earn-out, except it applies to the financial year that will be completed while the deal is being closed.

Deep Catch needs to achieve a minimum earnings before interest, tax, depreciation and amortisation (EBITDA) of N$129m in the FY21 financial year, in order to receive a payment of N$128,4m. If they achieve at least 90% of that target, they receive 80% of the payment. If they miss the target by more than 10%, then just 50% of the payment will be made.

A clever earn-out

The management team of Deep Catch will be hanging around for a few years. They just won’t be shareholders anymore. To keep them focused on the prize, Imperial put in place a great earn-out structure.

There are specific EBITDA targets for each of the next three financial years (FY22, FY23 and FY24). A payment is triggered each year based on the result achieved, with a miss of more than 10% resulting in just 50% of the amount being payable.

It sounds harsh until you remember that the biggest risks in this deal sit with Imperial’s shareholders.

An additional risk to Imperial is that Deep Catch could have one terrible year, causing the management team to give up on the earn-out. This would leave Imperial with a disaster to try fix. For that reason, there’s a catch-up provision that works off average EBITDA over the three-year period. In other words, a shocker in FY22 can be rectified by a great year in FY23, which would allow the management team to still earn the full price.

Finally, to give the management team an upside incentive, there’s up to N$40,7m available if the cumulative EBITDA for the next three years exceeds the target. That will work on a sliding scale I’m sure, but the announcement doesn’t give any details.

A final note on the “joy” of mergers and acquisitions

If JSE management teams had been more sceptical of their bankers and advisors in recent years, the returns on the JSE would look far better. Crazy offshore transactions destroyed billions of rands in shareholder value.

Risk mitigation tools are critical. If you see a major acquisition and there are no earn-outs involved, it’s time to get scared.

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