The formulas, tricks and trade secrets of Private Equity
Earn Outs Private Equity
Earnout payments for deals that were settled recently are unlikely to be paid as vendors see their businesses come under unprecedented pressure from the global financial crisis. As an indirect result, we’re seeing a lot of conjecture around the fairness of earnouts. Vendors are asking, why are we carrying your future risk after we’ve absolved ourselves of the business’s future profits?
The apathetic response is one referring to legal terms, the agreed contract and the unfairness of life. However, having a remorseful vendor is a terrible outcome for a multitude of reasons. So, it’s important to communicate the concept of earnouts in a way that doesn’t portray unfettered avarice on the part of your firm. The lucky part is that earnouts really do have their place and tend to be quite fair. Here are the two main reasons:
Firstly, the purpose of an earnout is to align interests. We need alignment because there is significant influence and information asymmetry. That is, the vendor knows much more about the business and has much more influence on the business than the new owner has. So, the buyer needs some comfort that the vendor will help to facilitate a successful hand-over.
Secondly, earnouts can increase the value of the deal for the vendor. The reasoning is that the cost of capital for the average vendor is lower than the cost of capital for a private equity buyer. This means that a deferred earnout payment may allow the private equity firm to pay more for the business, from the perspective of the vendor, while really paying the same amount from their perspective. This can help bridge the gap between value expectations, which is the cause of most problems in private equity deals.
With all of that said, the simplest way to communicate the fairness of earnouts is in terms of risk and reward. An earnout allows a buyer to pay a higher reward by reducing the risk. (The risk is that the vendor negatively influences the business, or doesn’t drive the business as hard, during the hand-over period.) I don’t for a minute buy the idea that an earnout should protect the buyer from economic and market movements. They are risks in any business and the new owner should be solely responsible for absorbing the outcomes.
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