What is the best way to structure a deal with earn-outs?

Earn-outs mitigate risk for buyers by linking a portion of the purchase price to future performance. This encourages thorough due diligence and provides a safety net if the business doesn't perform as expected.

In the current buyer-friendly market, it’s sometimes impossible to structure the exit without an earn-out. As financing in VC deals gets harder, startups should be ready to give VC funds earnouts to bridge a valuation gap.

Earn-outs can be structured using various financial metrics (e.g., revenue, profit, customer growth) or non-financial milestones (e.g., product launches, partnerships). Careful design of earn-out terms is crucial, addressing potential disputes over performance measurement and target achievement. Independent third-party verification of results can enhance trust and transparency. Currently, earn-outs are increasingly employed in technology and healthcare sectors due to rapid innovation and uncertain valuations. Consider alternative risk-sharing mechanisms, such as contingent value rights or milestone payments, depending on deal specifics. Integrate earn-out terms with broader business strategies and cultural fit considerations.

Earn-out disputes often arise from vague or poorly defined performance metrics, enabling manipulation or misinterpretation. Buyers can mitigate risks by establishing clear metrics, independent verification processes, and robust dispute resolution mechanisms. Sellers can protect themselves by negotiating fair terms, securing warranties, and considering alternative deal structures. The current economic climate and rising interest rates may lead to more earn-outs as buyers seek to manage risk and sellers strive for higher valuations. Consider using escrow accounts or third-party guarantees to secure earn-out payments and foster trust. Align earn-out milestones with long-term strategic goals to promote collaboration and shared success.

Both parties should establish clear and transparent terms in the agreement. Define the metrics, measurement methods, and dispute resolution processes meticulously to minimize potential conflicts.

One of the trickiest parts is defining milestones that trigger payment and make sense in the business context, such as financial metrics like revenue growth, or non-financial ones like product launches or new clients signed.

In the payment terms, provide explicit details on how, when, and the amount the seller will receive based on performance. Address potential adjustments, caps, floors, and escrows, and define triggers or events that may affect the earn-out's outcome.

Consider using scenario planning and sensitivity analysis to assess potential earn-out outcomes under different market conditions. Incorporate ESG (environmental, social, and governance) metrics into earn-outs to promote sustainable value creation. Explore the use of artificial intelligence and machine learning to improve earn-out performance tracking and forecasting. Earn-out usage has evolved over time, reflecting economic cycles, industry trends, and regulatory changes. Recent advancements in financial modeling and data analytics have refined earn-out design and measurement.

Clear and frequent communication between parties throughout the earn-out period is crucial to prevent misunderstandings and foster collaboration. External factors beyond the control of either party can impact earn-out performance, necessitating mechanisms for adjusting targets or resolving disputes. Cultural fit and shared values between buyer and seller contribute to earn-out success, as they promote trust and alignment. Recent trends in venture capital, such as larger and later-stage deals, have contributed to the increased prevalence of earn-outs. Consider incorporating mechanisms for early termination or buyout of earn-outs under certain conditions to provide flexibility and manage risk.

Earn-out usage has fluctuated over time, often increasing during periods of economic uncertainty, when buyers seek to mitigate risk and sellers strive for higher valuations. It's crucial to acknowledge that even well-structured earn-outs can face challenges, requiring flexibility and a willingness to compromise. Misaligned incentives can arise if earn-out targets incentivize short-term gains over long-term value.

Earn-outs are typical compensation mechanism in oil and gas license transactions, commonly referred as contingent payments. It is a mechanism to make the deal happen, especially when parties are of different opinion about the maturity of the projects and future oil/gas prices. It is important that the terms of the earn-outs are clearly reflected in SPAs. Future milestones need to be clearly defined and valuation methodology needs to be agreed upfront. One approach can be applying different risking percentages to the valuation at different stages of the project and define the key milestones which will reflect de-risking points in time. Meeting the milestone will mean increase in valuation, as such trigger contingent payment.