Page 8 - TACC 2023 Program

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20TH ANNUAL ACG CAPITAL CONNECTION

Earnout provisions in private equity deals grew in 2023

rivate equity’s worth and what a buyer is willing to pay. Earnouts “That makes [fund managers], perhaps, a little bit
share of are the “go-to tool” to get deals done when more amendable to using an earnout, because
Pglobal M&A the macroeconomic outlook is clouded with now you can make the exit on the timeline that
deals featuring an uncertainty, said Liam Timoney, a partner at law [investors] are asking you, but you’re not leaving
earnout provision fi rm Goodwin and member of its private equity potential value on the table that buyers wouldn’t
rose last year to practice. be willing to provide or pay up front at closing,”
its highest level Wallen said.
since 2020 as fund Timoney added that earnouts are “heavily
managers leaned on negotiated and it’s signifi cant chunks of the Private equity exits with earnout provisions
deferred payments potential consideration.” accounted for 5.8% of private equity exit deal
to close transactions Kip Wallen, senior director at M&A advisory SRS value in 2023, the highest percentage since 2020,
in a challenging according to S&P Global Market Intelligence data.
DYLAN THOMAS dealmaking Acquiom Inc., said earnouts factored into roughly
Private Equity environment. one out of every three private market deals the The prevalence of earnout provisions in private
Reporter, S&P Global fi rm saw in 2023, well above the typical one- equity deals is likely to remain elevated in 2024,
Market Intelligence The value of all out-of-fi ve ratio it has observed in the past. That Timoney predicted. While there are early signs
announced M&A estimate does not include transactions in the life that M&A activity will pick up, and earnouts
deals with earnouts sciences sector, where earnouts are much more could be expected to fade in a more competitive
totaled $73.11 billion globally in 2023, falling 34.2% common, Wallen added. deal environment, there is still a healthy dose of
from $111.06 billion in 2022 as overall M&A activity Wallen said the prominence of earnouts in recent
slowed in 2023, according to S&P Global Market private equity deals signals that private equity uncertainty in the outlook, not least because of an
Intelligence data. Private equity- and venture fund managers are seeking creative solutions upcoming US presidential election, he said.
capital-backed deals accounted for 26.5% of the “Private equity sponsors value stu based on
2023 total, up from 17.3% in 2022. to exit portfolio companies and return profi ts to
investors. Private equity’s typical hold period for multiples of earnings, typically, and that’s based on
Earnouts link a portion of a company’s sale price portfolio companies lengthened to 7.1 years in the assumption that those earnings will continue
to its future performance, and they are typically 2023 as of mid-November, up from an average of into the future. And with economic climate, with
used to bridge the valuation gap — the di erence 5.7 years in 2022, according to S&P Global Market the uncertainty, the confi dence is not always there
between what a seller thinks the business is Intelligence data. that those metrics will continue,” Timoney said.

The Founder’s Farewell – Parting Ways with the Founder’s

Business Baby

ou started the founders make all of the required fi lings known as an “earnout.” In this structure, part of
a business; on a timely basis? Did the founders make the consideration is only paid out when and if
Yyou poured disproportionate distributions? Neither the buyer certain performance measures are met. From a
your blood, sweat nor the founder sellers want to discover that a buyer’s perspective, this helps to ensure that it
and tears into the subchapter S election made by the founders either will not overpay if the business does not deliver
business for the failed inadvertently at the time of fi ling or was later on its projections. From the seller’s perspective,
past 20+ years; inadvertently terminated. The consequence of however, earnouts contain risk that the sellers
your children are an invalid S election can be disastrous, resulting may not have su cient control of the business
not interested in the in the entity being taxed as a C corporation post-closing to allow them to satisfy the earnout.
business; and you rather than as a pass-through entity, resulting in Accordingly, earnout provisions are typically
are ready to move potentially signifi cant historic tax exposure at the heavily negotiated.
on. It is time to sell. entity level. In preparing for a sale, it is important
GEMMA Now what? Be Kind to Me and my Baby.
DESCOTEAUX to assess the validity of any elections made and
avoid uncomfortable surprises.
M&A Partner, You are a strategic For many founders (and second-generation
Sheppard Mullin acquirer. You have Should I Stay or Should I Go? sellers) selling the business that they or their
Richter & Hampton identifi ed a founder- family members built may feel like selling a child.
owned business Frequently, a portion of the value of a founder- It’s critical that the advisors on both sides of the
that would be highly owned company does not lie in its tangible deal be accustomed to working with founders.
accretive and is a personal property, real property, or intellectual Nothing alienates a founding seller faster than
strategic fi t for your existing business. Now what? property; it often lies in the talent of the founders, a buyer or professional who talks down to the
or the company’s key executives, engineers and sellers or patronizes them. In addition, particularly
Buying or selling a founder-owned business developers. In these circumstances, both buyers
comes with its own unique challenges that make and sellers must ensure that these key individuals where a strategic buyer is concerned, the
it di erent from doing deals with other ownership are properly incentivized to remain with the sellers are often concerned about sharing their
structures. Consider the following: organization going forward and drive the business proprietary information with a competitor. Using
a clean team which allows only specifi c buyer
Taxation; Where did the Purchase Price Go? after the deal is closed. In certain cases, as painful personnel and third party advisors to have access
as it may be to contemplate, founders should to highly sensitive information, can go a long way
Congratulations! You’ve negotiated the purchase consider the possibility that the buyer may not
price! Now comes the tricky question: how much want them to stay around for long, if at all, post- towards allaying those fears.
of the purchase price will the founder sellers closing and should emotionally prepare for an Conclusion
actually see? Taxation can make or break your abrupt end to their relationship with the company
deal. Did the founders make a subchapter S that they built. If you assemble the right team of professionals,
election, electing to have the company taxed as plan ahead, and conduct the process in a
an S corporation rather than a C corporation? Was In circumstances where there is particular risk respectful, diligent, and straight forward manner,
the subchapter S election valid? In preparing of unwanted founder departure, the buyer the purchase and sale of a founder-owned
for the deal, did the founders do some estate may want to pay part of the purchase price as business can be a rewarding and satisfying
planning and move their stock into a trust? Did contingent consideration in what is commonly experience.