Strategic buyers increasingly dangle earnouts to win deals

12 November 2020

Last month, Freshly, a meal delivery company, sold to Nestle [SWX:NESN] for USD 950m; this week, Supreme, the street fashion brand, sold to clothing giant VF Corp [NYSE:VFC] for USD 2.1bn. Both deals included an earnout component.


An earnout provision, typically one to three years in duration, allows a seller to receive additional payments after a deal closes if the acquired business hits certain agreed goals.   


While not a new concept, earnouts have been on the rise since the onset of the coronavirus pandemic as a tool to bridge valuation gaps and to share future risks between buyers and sellers, M&A advisors say.


The length of earnout periods and their size as a percentage of deal value has also been ticking up in many cases.


M&A attorneys caution, however, that it is imperative to make the terms of earnouts very clear, to avoid future disputes down the road. 


Strategic buyers getting creative  


Nestle’s nearly USD 1bn takeover of meal delivery service provider Freshly offered potential earnouts of as much as USD 550m, “contingent to the successful growth of the business,” per the deal’s terms.   


Freshly, which had already sold a minority stake to Nestle in 2017, likely avoided having to raise another round of capital by selling the remaining interest to Nestle, said Daniel Sokolovsky, the CEO of AxleHire, a same-day delivery company. An earnout can also help motivate the staff of a target company to help it stay excited to grow, he added.


“Strategic buyers are getting more creative,” Sokolovsky said. Many conglomerates started venture arms over the last five to seven years, he also pointed out.


Nestle, in turn, sees Freshly as an “accelerant” to its business as it expects the shift to e-commerce and eating at home to stick, Steve Presley, CEO of Nestle USA, said in an interview with news service Cheddar. Freshly, led by its CEO and co-founder Mike Wystrach, will operate as a separate company under the Nestle USA umbrella.


Nvidia [NASDAQ: NVDA], Coca-Cola [NYSE: KO], and Diageo [LON:DGE] also employed earnouts in major acquisitions this year, according to Mergermarket data. 


Adapting earnouts for post-COVID dealmaking  


Strategics are not the only acquirers turning to earnouts: middle-market private equity firms also used these provisions to get deals done during the most uncertain period of the pandemic, this news service reported in May.


“We are seeing more deals with earnouts in the middle market, especially for companies in industries that are not COVID-resilient,” according to Paul Pryzant, a partner with Seyfarth Shaw.   


If parties are keen to strike a deal but are uncertain about the target’s earnings trajectory in the next few years given the possibility of a resurgence of the pandemic, an earnout could be “a really great way to bridge the gap,” he explained.  


Pryzant said he has seen a number of deals that were put on hold due to the pandemic but are now able to close after restructuring, including by using an earnout or an equity rollover to overcome disagreements on deal price.


Franklin McClelland, a Vice President at SPX Corporation [NYSE: SPXC], echoed that having an earnout can be a good solution in an environment “where there’s a gap to fill between historic performance and forward-looking outlook.”   


His comments came at an October panel during the Mergermarket US Corporate Development Summit, where he talked about SPX’s recent acquisition of ULC Robotics, which included a total cash consideration of USD 90m, with contingent cash payments of up to an aggregate of USD 45m to be paid in 2021 and 2022.   


SPX started discussions with ULC in early spring, but the negotiations grew more complicated during the pandemic. 


“We think long-term, this is an attractive opportunity for both sides, but a straightforward cash deal just didn’t make sense in light of everything going on,” he said. The earnout, instead, offered a value-creating opportunity for the seller while also reducing risk for SPX, he said.  


Extended earnout length and more flexible metrics  


Not only has the pandemic prompted the use of earnouts in deals, but it is also impacting how terms are structured, according to Chris Letang, managing director at SRS Acquiom.   


Before COVID-19, around 15% to 20% of M&A transactions utilized an earnout, with these agreements most commonly structured over a one-year or shorter period, according to Letang. He expects more earnouts could now last for two years or even longer, and may account for a higher percentage of the transaction value. 


In perhaps one of the more extreme examples, Diageo’s acquisition of Davos Brands, the New York-based spirits company co-owned by actor Ryan Reynolds, the deal includes an initial payment of USD 335m and an earnout of up to USD 275m based on the performance of Aviation American Gin over a 10-year period.


Pryzant agreed that sellers may negotiate longer earnout periods, as it allows for more time to cope with uncertainty and gives them a better chance of achieving their milestones. On the other side, buyers attempting to find a bargain may prefer to make a lower portion of their payment upfront.  


While life sciences transactions mostly have earnouts dependent on metrics around regulatory approvals, 65% of deals in technology and other sectors use revenue tests, according to Letang.   


In a recent podcast with Mergermarket, Letang and Pryzant discussed how the shift from a seller’s to a buyer’s M&A market this year has impacted deal terms and led to the increased use of deferred payments, among other changes.  


There have been a variety of ways to design earnout provisions in deals announced this year. For example, Nvidia’s acquisition of UK chip developer Arm was valued at USD 40bn, including up to USD 5bn in cash or stock earn-out payments upon meeting “specific financial performance targets.”  


Additionally, E. & J. Gallo Winery last year agreed to buy a portfolio of wine and spirits brands from Constellation Brands [NYSE:STZ], but in May restructured the transaction to address antitrust concerns, removing assets from the deal and reducing the price to approximately USD 1.03bn, of which USD 250m is an earnout based on “divested brand performance over a two-year period.” Net sales of Constellation’s wine and spirits division fell by 11% in the three months to 31 August 2020, compared to the same period in 2019, according to the company.  


Delayed risks in dispute 


Despite the promising upsides, earnouts can set up deal parties for possible disputes when they go to calculate earnout rewards. 


“I kind of jokingly say it’s practice development for my litigation partners because, in my experience, at least a third to a half of these things end up into some sort of a dispute,” said Michael Bernard, a member of the corporate finance group at Dykema. 


Disputes often arise over the operations of a business post-closing, where, for example, sellers argue they don’t have enough control of the acquired business or fail to get adequate investments from the buyer to achieve the earn-out goal, Bernard explained. 


It is key to understand the universe of operations that will drive the metrics that determine the earn-out payment, according to Curt Hearn, a partner and co-lead of the corporate practice group at Jones Walker. 


“This dynamic is always true, but it is even more complex in a COVID-environment,” he said, where deal parties may not have contemplated or discussed actions responsive to the pandemic at the time of the earnout’s negotiation.


When it comes to solving earnout disputes, most parties will attempt to resolve the issues between themselves rather than enter litigation, both Hearn and Bernard said. This is partly because buyers want to be mindful of whether to “push really hard” on the dispute if the counterparty is continuing to run the acquired business or has a significant influence over its team, the latter said.


“You may end up antagonizing a key management person,” Bernard cautioned. 


To avoid disputes over earnouts, a lot of work can be done by M&A lawyers during the deal negotiation stage, where they can draft explicit and specific provisions in the agreement tailored to the acquired business, Pryzant said.


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