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Earnouts: The Key in Overcoming Valuation Challenges in the Current M&A Landscape

In today’s intensely competitive business environment, mergers and acquisitions (M&A) have emerged as a key strategy for growth and value creation.

One of the pivotal challenges faced by both buyers and sellers in the current M&A market is bridging the valuation gap, which typically widens during economic downturns. As we observe the M&A market trends in 2023, it’s clear that the echoes of 2022 continue to affect the landscape.

Buyers are adjusting their valuation expectations downward due to market conditions like rising inflation and expectations of higher-for-longer interest rates. Sellers, however, have yet to realign their outlook. Most sellers still foster optimism from extended periods of historical growth, while others are anchoring their expectations to the multiples of a couple of years ago. This divergence in valuation expectations has cast a pall of uncertainty over ongoing transaction activities, perceived by sellers as a transient pricing compression and by buyers as a period of ambiguity.

As buyers navigate the intricacies of deal-making, contingent consideration, or earnouts, have emerged as a potent tool to bridge these valuation gaps and align interests between buyers and sellers to get deals across the finish line. According to a recent market study, nearly one-third of closed buyout deals have had an earnout in 2023. For context, the percentage was in the high teens during 2021 and 2022.

Earnouts entail sellers receiving a portion of the purchase price in the future, contingent on the target company achieving predefined results or milestones. Earnouts can be based on a variety of profit and/or other measures, including, for example:

• Revenue growth;
• EBITDA/net income margin thresholds and/or growth; and,
• Operational milestones like product approval or customer retention.

Given the elevated use of earnouts as a tool for M&A, it is even more critical to understand and manage the economic and financial reporting considerations inherent in their use.

How Centri Can Help

Centri’s valuation specialists can advise buyers and sellers on the fair value of any contingent consideration included within the purchase price of the deal as well as the range of expected value within a given confidence interval to better understand the balance sheet impact and assist with deal negotiation. Furthermore, in partnership with the technical accounting teams, Centri assists in the financial reporting of the business combination, including technical accounting memos, preparation of the closing/opening balance sheet and walk across files, determination of the fair value of purchase consideration, and allocation of purchase price to assets acquired and liabilities assumed. This ensures a smoother, more efficient acquisition process. Contact us to learn more.

Curtis Farrow

Partner | Private Equity & Venture Capital Practice Leader | CPA, ASA

Curtis is a Partner at Centri Business Consulting and the leader of the firm’s Private Equity & Venture Capital Practice. He has more than 11 years of experience and has supported many clients in achieving their growth initiatives in connection...

Manhar Mayank

Senior Manager

Manhar is a Senior Manager at Centri Business Consulting within the Valuation Practice. He has more than 10 years of valuation experience. He joined Centri in August 2023 and has performed business valuations for business...