Navigating value uncertainty: Earnouts are on the rise in deals

The worst health crisis in more than a century and a sudden, deep economic recession have created a volatile environment for businesses in several industries and the most uncertain deal landscape in decades. After spiking in March, the Cboe Volatility Index (VIX), which measures the stock market's expectation of volatility based on S&P 500 index options, has remained well above the levels of the last several years. The Global Economic Policy Uncertainty Index, created in 1997, hit its highest point in March 2020 and continued to rise through May. With few exceptions, companies are facing uncharted waters that have upended traditional growth strategies.

But uncertain times also present M&A opportunities, as companies seek both stability, by restructuring or right-sizing their organizations, and growth, as customer and market landscapes continue to shift. Compared to organic efforts, deals can be a faster and more efficient way to bring change, especially in an unstable environment. This strategic imperative to change and adapt quickly in this new environment, coupled with the greater amount of capital available for acquisitions compared to previous recessions, means deal activity could potentially recover more quickly than the overall economy in the months ahead.

Overcoming the value gap

One major challenge for buyers and sellers is overcoming the value gap in making deals, which grows when economic conditions worsen. Consistent with previous downturns, buyer expectations for lower valuations have grown as economic conditions worsen. But shifts in demand arising from the pandemic have also — either temporarily or permanently — impacted outlooks in both positive and negative ways.

Meanwhile, seller expectations have yet to recalibrate. Some are buoyed by the memory of a historically long economic expansion that elevated M&A activity, while others are leaning heavily on recent performance as the new baseline. While the size of this expectations gap will eventually align, it has clouded current transaction activity, with what sellers view as a temporary price compression and what buyers view as a period of uncertainty.

A key mechanism to address this gap is the earnout, which requires a seller to receive part of the purchase price in the future, based on the target company achieving certain results or milestones. Interest in earnouts as part of deals has increased since mid-March, according to PwC data; compared to what our teams saw before the crisis, the frequency has nearly doubled. We expect this interest to grow, with earnouts increasing over the next several months as buyers and sellers navigate the COVID-19 M&A landscape.

Drivers of uncertainty are on the rise

Several dynamics are contributing to what we believe will be a prolonged period of uncertainty for dealmaking:

• The current crisis is different: Compared with previous recessions, the current downturn has raised more fundamental issues in the overall business environment, ranging from changing consumer behaviors to challenges in workforce management. Most companies in various sectors are facing different types of changes in their business as a result of the pandemic — changes that are separate from challenges such as driving an organization’s evolution or pulling off large-scale growth.
• Business models are transforming: Even before the pandemic, businesses were facing formidable challenges, ranging from trade wars to adoption of new digital technologies. Many companies were addressing these challenges when the crisis hit, and some have explored investments in other industries. This trend has continued during the crisis; cross-sector deals were a larger percentage of total US deal volume in the second quarter of 2020 than in the same period a year earlier, according to a PwC analysis of Refinitiv data. Shifting priorities and limited management capabilities increase uncertainty in achieving the transformations necessary to stay competitive, such as enterprise resource planning, branding and market strategies, geographic expansion and other efforts. These will affect businesses’ baseline earnings power and market relevance, and will be critical to keep companies relevant in their sector. One big question is what happens to businesses and their earnings when these actions are deferred.
• Sector success is widely dispersed: Compared to results in the previous recession, business results in the current market are more widely dispersed at both the sector and individual company level. Certain businesses are struggling to convince buyers that their fundamentals are still sound and that this is only a temporary compression. Other companies are stable or even thriving as workforce, data, technology, and other needs and practices are evolving. They’re considering how to execute a transaction in a time of high growth, while avoiding the broader value compression in the deals market.
• Carve-outs and divestitures have more appeal: Consistent with behaviors in past recessions, some companies will try to reposition themselves or raise funds by selling pieces of their organization. While we do expect more carve-outs in the near future, the nature of these assets is more difficult to assess. Carve-outs have more uncertain earning profiles since they rely on certain centralized functions of the overall company. Earnouts can be a potential insurance policy against the risk of decreased operability of a carved-out entity.
• Credit markets tighten temporarily: Temporary compression of the credit market can also compress valuations. While the credit market compression may be temporary, a reduction in enterprise value — due to limited credit available to execute a transaction — has a permanent impact on transaction value for both buyers and sellers, making it even more difficult to bridge the value gap when closing a transaction.

The advantages and challenges of earnouts

Earnouts provide a cash flow benefit to the buyer by extending payment of part of the ultimate purchase price, and they reduce transaction risk by directly linking the price to the target’s post-acquisition performance. A buyer also can use earnouts to differentiate its bid in a competitive process — ultimately offering more than other potential acquirers — while still gaining protection against some of the uncertainty and risk regarding the target’s enterprise value and earnings power.

For a seller, earnouts may be the only way to bridge the valuation gap with a buyer. And for sellers with short trading histories, earnouts can provide an additional method to value businesses, as conventional valuation methods may be difficult.

But earnouts also mean less certainty at closing on the final purchase price, and potentially more challenging interim accounting that may require maintaining separate books. The buyer and seller also may have different ideas on how to manage the acquired business, with the seller more focused on short-term results to meet the earnout requirements, while the buyer has a more long-term view.

In addition, the cash flow delay could be an issue for a seller, which also usually can’t make an immediate clean break from the business due to the earnout. For buyers, earnouts could require finding future funding beyond the original credit facility to complete the purchase, and that financing could be more costly.

How earnouts are changing in the pandemic and recession

Earnouts can include various metrics for financial performance. Revenue-related earnouts are common, but in the deals our teams have seen recently that considered earnouts, more than half contemplated an EBITDA metric, internal data showed. That’s significantly higher than before the COVID-19 crisis. This greater focus on EBITDA indicates growing buyer concerns on targets’ ability to achieve overall profitability — rather than simply revenue — in the months ahead. But the use of an EBITDA metric also increases both the complexity of an earnout and the potential for dispute between parties.

Before the COVID-19 crisis, SRS Acquiom data showed that roughly one-third of earnouts had durations of one year or less. Recent earnout conversations show a shift from these shorter duration earnouts to longer durations of one or two years, and we are still seeing over one-third of earnouts with durations of more than two years, according to PwC internal data. This suggests that sellers may be pushing for somewhat longer earnouts due to substantial near-term uncertainty. That would allow more time to manage the impact of the pandemic and recession and turn a business around to meet an earnout threshold.

(For more details, please read How to structure an earnout, and considerations in the current environment or listen to our latest podcast, Understanding earnouts in the current environment.)

Potential disputes in earnout discussions — and how to avoid them

Given the elevated interest in earnouts, it’s even more critical to manage disputes and agree on conditions before closing to avoid any confusion and clashes down the road. The divergence in interests — short-term for sellers, long-term for buyers — can often frustrate the earnout process even in good economic times. The current uncertainty likely will increase pressure on the parties in these transactions. In our experience, earnout disputes usually fall into three key areas:

• The calculation of the performance metric in line with past practice: The performance metric defined in an earnout typically requires consistency with the buyer’s accounting practices. This can create challenges if those practices and reporting requirements are different from the seller’s practices. Any changes asked of the seller can open the door for disagreements.
• The treatment of non-recurring, one-time adjustments in the performance metric used to determine achievement of the earnout: Adjusted EBITDA targets for earnouts often exclude “non-recurring,” “unusual” or “one-time” items with the intention of measuring maintainable performance. This is fraught with problems and a frequent area of dispute, as the definitions are seldom well-defined. Does non-recurring mean something that will never occur again, or that is unlikely to occur within a certain time frame? Is anything truly “one-time,” and how can you prove that? What is considered unusual by one party can reasonably be argued as ordinary or unexceptional by another.
• Post-closing operations of the acquired business and obligations to operate it similarly to the seller's past practice: During the earnout period, a buyer is typically required to run the business “in good faith and fair dealing,” “consistent with past practice” and subject to other specific covenants. When determining why an earnout was or wasn’t met, parties may rely on these operating covenants and attempt to argue that a breach has occurred. The state of Delaware — where more than one million companies, including two-thirds of the Fortune 500, are incorporated — has generally held that a buyer has no obligation to take or refrain from taking action, and no implied obligation to use best efforts to maximize an earnout. The courts have held that the implied covenant of good faith and fair dealing prohibit a buyer from proactively trying to limit the achievement of earnout targets, but legitimate business decisions aren’t seen as such actions. This becomes increasingly challenging as businesses are more closely integrated. In many disputes, sellers are frustrated with how buyers have run the business after the acquisition closed, and sellers attempt to argue there was a breach. Parties should be thoughtful up front and work with legal counsel to draft specific operating covenants.

(For more information on each of the above areas, please read Examples of disputed areas in earnouts.)

In tenuous economic times, buyers and sellers will need to be flexible in aligning their views of go-forward profitability and the operations of a business, especially when it comes to the impact on valuations. Earnouts can help bridge the value gap and mitigate the risks in a transaction. If an acquirer and a target can successfully negotiate a well-structured earnout, the deal ultimately could deliver value for both parties.

PwC Director Arash Razaghi and PwC Manager Alex Barney contributed to this article.