In uncertain markets, creative deal structuring can empower companies to move forward with mergers and acquisitions (M&A) while minimizing downside risk. One of the most effective tools for navigating volatility is contingent consideration, a mechanism that helps protect against unforeseen disruptions. This strategy is effective for both short-term risks (like an economic recession) as well as longer-term risks (like the disruption from a new technology).
This article explores how companies can leverage contingent consideration to mitigate risk in deals. Planning an M&A deal? The team at Acquinox Advisors can help you craft a resilient deal structure tailored to your goals and risk tolerance.
Contingent Consideration: Protecting Both Buyers and Sellers
Contingent consideration, also known as an earnout, is a provision in a merger or acquisition where an acquiring company agrees to pay additional cash or equity to the sellers if agreed-upon operational or financial goals are met.
These deals are fairly simple in theory, often following an “if, then” structure. If a certain goal is met, then a specific amount of money or equity is paid.
However, they’re often more complex in practice due to the almost unlimited number of ways that a deal can be structured. During the negotiation process, companies will have to answer questions like:
- How much money will be paid up front? How much will be paid later on?
- Will the payouts be in cash, equity, or both?
- What goals need to be satisfied for the payout to be released?
- When will the payments be released?
- What events or stipulations can cause the payouts to be canceled?
Given the number of moving parts, incorporating contingent consideration can quickly add complexity to a deal, no matter how small.
Examples of Contingent Consideration
Contingent consideration can be linked to just about any business goal. Here are a few common examples:
- Contingent Lump Sum Based on Profitability: When a one-time payment is sent to the acquired company after it achieves a specified revenue or income threshold.
- Revenue-Based Milestone Payments: When a series of installment payments are made to the acquired company after it reaches a defined revenue growth target.
- Non-Financial Performance Triggers: When payouts are tied to non-financial benchmarks, such as employee or customer retention goals or the successful launch of a new product.
- Retention Bonuses for Key Executives: When payouts are awarded to executives who remain with the company for a designated period following the acquisition.
- Earnouts Tied to Continued Employment: When payments to the sellers are contingent on remaining employed with the company for a specified amount of time.
Advantages of Contingent Consideration
Contingent consideration is designed to align incentives and protect the interests of both buyers and sellers. When structured creatively, it can offer mutual advantages and significantly increase the likelihood of a successful transaction. Some of the most common benefits for the acquiring company include:
- Reduces Upfront Deal Value: Tying part of the purchase price to future performance allows acquirers to avoid overpaying if the target fails to meet growth expectations. This is particularly useful when growth forecasts might seem overly optimistic.
- Aligns and Incentivizes Leadership: Contingent payouts encourage the target company’s management team to remain involved post-acquisition and stay focused on hitting strategic goals that drive long-term success.
- Lowers Immediate Cash Requirements: Structuring a portion of the deal as future payments, whether in cash or equity, can ease pressure on the buyer’s balance sheet and preserve liquidity during uncertain market conditions.
Conversely, here are some of the benefits for the target company:
- Larger Deal Price: The target company has the opportunity to negotiate a higher deal price by making part of the payout linked to their financial performance. As long as the company reaches its projections, the management team will be fairly compensated.
- Higher Earning Potential: By negotiating payment in equity, sellers have the potential for greater future earnings as the company grows.
- Greater Deal Certainty: Agreeing to a structured, milestone-based payout can help move the deal forward when valuation gaps exist. This flexibility often increases the chances of closing the deal while still rewarding the seller for future performance.
Accounting, Legal, and Tax Implications
While making deal structures complex can be a great way to mitigate risk, it inevitably leads to more complex accounting, legal, and tax hurdles.
For example, future earnouts are often taxed differently from traditional compensation, especially if those earnouts are in equity rather than cash. This creates complex accounting and tax challenges for all parties involved that also need to be considered while negotiating and closing the deal.
Structure Your Deal For Success in Uncertain Markets
In today’s unpredictable economic environment, contingent consideration offers a flexible, performance-based mechanism that can help companies continue to pursue deals while simultaneously mitigating risk.
By linking part of the purchase price to future performance, acquirers can avoid overpaying while sellers maintain the opportunity to maximize their outcome, creating a win-win structure that supports long-term success.
However, these arrangements come with their own set of challenges. From defining performance triggers to navigating complex tax and legal implications, contingent considerations require careful planning and expert execution.
Planning an M&A transaction? The experienced team at Acquinox Advisors can help you create a customized deal structure that protects against unforeseen circumstances while maximizing upside potential.
