Earn-out modeling between seller and buyer

Hello Folks,

Small technical question here.


When there is an earnout between seller and buyer, I understand payment will be usually performed at the time of exit(buyer exit).

But is there any interim earnout-payments during investment period? Have you seen any of this case?

e.g., 'company' pays earn-out cash to 'seller' if EBITDA exceeds certain threshold during investment period.


Context for this question is earn-out is usally applied to buyer-seller relationship. So we don't have to worry about 3 statements model as buyer can use Equity proceeds to payout earnout.

But during investment period before exit, seller cannot guarantee paying cash to buyer because there is no exit proceeds yet.

So, can we model in earn-out payment before UFCF level?

 

Based on the most helpful WSO content, earnouts are indeed typically structured to be paid upon certain performance milestones, which can include periods during the investment rather than solely at exit. Here’s how you can think about modeling interim earnout payments:

  1. Identify Performance Metrics: Determine the specific EBITDA thresholds or other performance metrics that trigger the earnout payments. These should be clearly defined in the acquisition agreement.

  2. Timing of Payments: While earnouts are commonly associated with exit events, they can indeed be structured to allow for interim payments if certain performance milestones are met during the investment period. This needs to be explicitly agreed upon between the buyer and seller.

  3. Modeling in Financial Statements:

    • Income Statement: Since earnouts are contingent liabilities, they do not typically appear until the obligation is deemed likely. If an interim payment is triggered, it would be recorded as an expense.
    • Cash Flow Statement: The actual cash outflow from earnouts would be reflected in the financing section if it's funded from equity proceeds or in the operating section if it comes from operational cash flows.
  4. Source of Funds: During the investment period, if the company performs well and generates sufficient free cash flow, this can be a source for earnout payments. Alternatively, if structured within the terms of the agreement, additional equity injections from the buyer could fund these payments.

  5. Financial Modeling Considerations:

    • When building your model, include toggles for earnout payments that can be activated based on the achievement of the predefined performance metrics.
    • Consider the impact of these payments on the company’s cash flow and debt levels, especially if the earnout payments are substantial.
  6. Risk Assessment: It’s crucial to assess the risk of such arrangements. If the business does not generate expected cash flows, it might strain the financials if earnout payments are still obligated.

In summary, while earnouts are commonly associated with exit events, they can be structured to include interim payments based on performance during the investment period. This should be carefully modeled and negotiated to ensure it aligns with the financial health and cash flow projections of the company.

Sources: Overview of Sell-Side M&A, How To Record Earnout Paid in LBO Context?, How Private Equity Owned Companies Fund Add-Ons, NEW Financial Modeling Training Courses, Biotech finance part 2: valuation methodologies and modeling considerations

I'm an AI bot trained on the most helpful WSO content across 17+ years.
 
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Most earnouts in LMM/MM are 2-3 years after acquisition of the platform or tuck in depending on the case. Contingent liability recorded on BS at NPV and likelihood, possible mark to mark on IS/CF. Payment is either, cash on BS, equity injection from sponsor or depending on CA can be paid from debt facility.

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