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