In a deal structure known as a “earnout,” a portion of the acquisition price of a firm is postponed and dependent on its future performance. Earnouts can provide a number of advantages to both buyers and sellers, including the chance to spread out the final purchase price over time and pay less up front. To get at a deal that both parties can accept, they necessitate significant negotiation and meticulous structuring.

Due to their capacity to lower upfront costs and lessen risk on the buyer’s side, earnouts are a common transaction structure during periods of economic recession or uncertainty.

They also give a buyer confidence that the seller is motivated to make sure the company succeeds after the acquisition. Earnouts are a means for the buyer and seller to bridge the value gap in the absence of bidders willing to pay the full asking price, giving the seller a greater sale price over time. An earnout structure is a sort of deal structure where a seller negotiates a higher upper end for the purchase price while leaving a portion of the consideration on the table, subject upon future performance. This can help a seller acquire a valuation that is more in line with (and occasionally even greater than) what they would typically hope to get.

What are the Benefits of Earnouts for MSPs ?

MSPs looking to enter the M&A market can use earnouts to their advantage during economical downturns and times of uncertainty. Here are several ways earnouts can help MSPs maximise value on their deals:

• Bridging Valuation Gaps: As with any business, there can be a discrepancy between what a seller believes their MSP is worth and what a buyer is willing to pay. In these instances, earnouts can bridge the gap. They allow sellers to attain a price more aligned with their expectations, contingent on future performance. This can be especially relevant for MSPs that are innovating or expanding into new service lines where the future revenue potential may not yet be fully realised.
  
• Mitigating Client Churn Risk: For MSPs, customer relationships and recurring revenue are key business drivers. An earnout structure that rewards maintaining and growing these relationships can provide reassurance to the buyer that key clients will not be lost in the transition. This risk mitigation can justify a higher purchase price, benefiting the seller.
  
• Incentivising Innovation and Growth: The earnout structure can incentivise sellers to continue growing the business post-sale, which can be particularly beneficial for MSPs. If the MSP is developing new technology or expanding its service offerings, an earnout agreement can ensure the seller benefits from these innovations even after the acquisition.
  
• Facilitating Knowledge Transfer: In the MSP business, the sellers often hold key technical and customer relationship knowledge. An earnout arrangement encourages the seller to remain involved post-acquisition, thereby ensuring a smoother knowledge and client relationship transfer, ultimately leading to continued business success.
  
• Attracting More Buyers: Earnouts can make an MSP more attractive to potential buyers, especially those who might be cautious about paying a high upfront price. By linking part of the payment to future performance, buyers can feel more secure about their investment. This can widen the pool of potential buyers for the MSP.
  
• Leveraging Synergies: If the MSP is being acquired by a larger firm with more extensive market reach or complementary services, an earnout allows the seller to benefit from the synergies that may arise post-acquisition.

However, these arrangements can also carry significant risks and challenges. Any company considering an earnout should carefully weigh these factors and seek professional advice.

The Risks of Using Earnouts

Earnouts can also present significant difficulties, dangers, and drawbacks. The main disadvantage for sellers is the uncertainty created by linking a siseable percentage of the sale price to the company’s future performance. Typically, sellers will have the following worries: Are the earnout goals achievable? Are the anticipated future payments sufficient to make up for not receiving the full amount now? How can the seller be certain that the purchaser won’t manage the company in a way that minimises or eliminates the earnout payment(s)?

Let’s delve into these concerns :

• Uncertain Future Performance: As with any business, the main risk for MSP sellers is the inherent uncertainty of future performance. Technology trends, market dynamics, and customer behavior all can shift rapidly. If an earnout is based on future revenues or profitability, changes in these variables can make the earnout targets unachievable.
  
• Dependency on Buyer’s Management: Post-acquisition, the buyer typically assumes control of the business, which can present a risk for the seller. If the buyer mismanages the MSP, changes its strategic direction, or fails to invest in growth, it could negatively impact the earnout. This is a crucial concern for MSPs, given the rapidly evolving nature of technology and the constant need for innovation and investment in new services.
  
• Disputes Over Earnout Metrics: MSPs often have recurring revenue models, which might seem straightforward for setting earnout metrics. However, disputes can still arise, for instance, if customers cancel contracts or if the buyer’s actions lead to loss of clients. Defining clear, quantifiable metrics for the earnout, like customer retention rates, revenue targets, or EBITDA levels, can mitigate this risk, but it still exists.
  
• Integration Challenges: For MSPs, integration into a new company can be complex, especially if the buyer has a different technology stack or corporate culture. If integration issues harm the business’s performance, the seller’s earnout can be reduced.
  
• Tax Complications: Earnouts introduce complexity into the taxation of the transaction for both buyers and sellers. Depending on the structure of the earnout, it may create unforeseen tax liabilities. Sellers in particular need to be aware of when and how earnout payments will be taxed.
  
• Distraction from Core Business Operations: The necessity to hit earnout targets might cause a divergence of focus from the long-term health of the MSP business towards short-term goals. This could have a detrimental impact on the business’s overall growth and stability.

It’s therefore important to remember that an earnout agreement can mitigate some of the risks inherent in an acquisition, but it can also create new risks and potential points of dispute. Therefore, careful thought, planning, and legal advice should be applied when considering such a structure.

How can MSPs Minimise Risks Associated with Earnouts?

In an earnout deal, clarity and simplicity are of paramount importance. The payment terms should be easily understood, and the targets should be challenging yet achievable. Factors like the length of the earnout period and the schedule of payments should be decided upon mutually. In the context of MSPs, these targets could be related to client retention rates, revenue growth, or reaching specific operational benchmarks.

The deal structure should consider the timing of payments, potential risks, and clearly define the roles of both parties during the earnout period. Considerations should account for changes in the business environment, market dynamics, competitive pressures, or unforeseen circumstances that could impact an MSP’s performance.

Control provisions that detail the involvement and authority of the buyer and seller during the earnout period should be incorporated in the agreement to avoid potential disputes. For instance, the agreement might specify that the seller remains in a key operational or advisory role to ensure continuity of service and client relationships.

Given the complexity of earnouts, both parties should seek advice from legal and financial professionals to ensure the earnout structure is legally valid, financially robust, and mutually agreeable. This is particularly important for MSPs, given the industry’s specific nuances and the rapidly evolving technological landscape.

One critical factor to consider with earnouts is the potential tax implications. In some cases, the earnout portion of the purchase price could be taxed as employment income rather than as capital gains, resulting in a higher tax obligation. To avoid this, the earnout agreement must align with tax authority standards, such as those set by HMRC. For example, tax rules often require that the seller remains employed during the earnout period, but that the earnout is not dependent on future employment and does not include personal performance targets. Also, non-employees or former employees must receive the earnout on the same terms as employees.

Moreover, to ensure that the earnout is taxed as capital gains, it must be part of the valuable consideration given for the securities in the target company. Sellers can utilise services provided by tax authorities to confirm this treatment. For instance, in the UK, HMRC offers a service to confirm that the earnout will be taxed as a capital gain. Qualifying sellers may also be eligible for Business Asset Disposal Relief, which can reduce the Capital Gains Tax (CGT) rate from 20% to 10%. (Please seek specialist financial advice)

Conclusion

As an acquisition tool, earnouts provide a compelling means for MSPs to maximise their value in a sale, particularly in uncertain or downturned economic environments. By aligning interests and sharing future risks, earnouts can bridge valuation gaps, incentivise continued innovation and growth, mitigate client churn risks, and attract a wider pool of potential buyers.

While earnouts do come with their share of challenges, such as uncertainty in future performance, tax complications, and potential disputes, careful planning and sound legal advice can help mitigate these risks. In an industry marked by rapid technological advancement and evolving customer needs, the strategic use of earnouts can be a potent tool in the MSP M&A playbook.