Earnouts gain traction in tech deals, bridging valuation gaps

As we enter the final quarter of 2024, the mergers and acquisitions sector continues to be hampered by high interest rates, inflation and geopolitical factors. The technology industry has not been immune to the sluggish deal environment, as the increased cost of capital has resulted in a sustained valuation gap between buyers and sellers. While the Federal Reserve’s 50 basis point rate cut in September is expected to serve as a catalyst for M&A, acquirers are still cautiously seeking positive signs in the economy to gain greater confidence in deal outcomes. With buyers prioritizing risk aversion and sellers failing to adjust to valuation expectations, parties must continue to explore creative ways to reduce the bid-ask spread and close deals.

Earnouts are a tool utilized when sellers believe their business is worth more than buyers are willing to pay. They allow buyers to defer a portion of the purchase price, contingent on the acquired company achieving certain post-closing milestones. By tying the seller to the company’s post-closing performance, buyers can help mitigate the risk of overpaying for a company that may not live up to expectations.

Historically, earnouts have been heavily utilized in the life sciences sector, typically tied to nonfinancial milestones such as the progress of certain clinical trials or obtaining regulatory approvals. Now they are becoming increasingly common across all industries. In fact, the SRS Acquiom 2024 M&A Deal Terms Study found that the inclusion of earnouts in private company deals increased significantly in 2023, with nearly one-third of non-life sciences deals containing an earnout provision, up from 21% in the prior year.

Earnouts make particular sense in the technology sector, given the inherent valuation complexities and volatile growth rates of tech companies compared to other industries. Many technology companies are earlier in their respective lifecycles and lack measurable track records of performance. They may not have significant tangible assets on their balance sheets, with much of their value derived from intellectual property and customer data. Further, while a portion of technology companies will turn the corner and hit the hypergrowth phase, many others will never reach that point. For these reasons, earnouts are an attractive option for sellers who are confident in their company’s future performance and buyers that want to balance their risk.

According to the SRS Acquiom study (excluding life sciences deals), the majority of private company earnouts are calculated based on revenue (64% in 2023) or EBITDA—earnings before interest, tax, depreciation and amortization (23% in 2023). However, the earnout metric typically depends on how the target’s enterprise value was calculated. For example, for subscription-based businesses, many earnouts are based on the achievement of certain annual recurring revenue thresholds. This way, the earnout is calculated on a metric that is meaningful to the company, without being skewed by one-time or nonrecurring transactions.

Earnouts are increasingly prevalent for middle market technology companies, as they may be in an earlier business stage and often have less sophistication around financial reporting or reliable projections, factors that underscore uncertainty of post-closing performance. And while middle market private equity firms may be sitting on record levels of dry powder, the current deal environment has seen buyers continue to hesitate through the first nine months of 2024. With the sustained inflationary environment and expensive debt capital markets, buyers must achieve a greater return on their more expensive cost of capital. Sellers, meanwhile, are only a few short years removed from the record-breaking valuation environment of 2021 and may not have adjusted their valuation expectations for today’s environment.

Significant dollars are at stake in earnout calculations, typically anywhere from 10% to 25% of the purchase price. As such, earnouts are often heavily scrutinized and ultimately contested by buyers and sellers alike at the conclusion of the earnout period, which typically ranges from one to three years after deals close. Whether due to ambiguous drafting of the earnout definitions, lack of illustrative examples, or post-closing decisions made by the buyer, many earnout provisions often wind up in dispute. For these reasons, parties who conduct robust due diligence and engage specialists in structuring the earnout in the purchase agreement will be best positioned to optimize deal value.

Given the interest rate cuts by the Federal Reserve announced in September, the presidential election, and a variety of other economic and non-economic factors, an uptick in M&A activity in the technology sector is expected in the last quarter of 2024 and into 2025. Considering that increase and continued uncertainty over valuations, earnouts will be a key mechanism that will ensure buyers and sellers get deals across the finish line.