The Hindu Business Line : Earn-outs are the in-thing in M&A deals

Earn-outs are the latest buzzword in IT merger and acquisition (M&A) deals. More and more M&As are being structured with an earn-out component these days.

Earn-out is mechanism wherein part of the acquisition cost is linked to future performance of the acquired entity and paid over a period by the acquirer.

This not only helps the acquirer retain key talent but ensures that the customers of the acquired company are retained going forward.

If the performance metrics are not achieved by any chance, the earn-out model would reduce the overall cost of acquisition for the buyer and thereby acts as a hedge against market and technology risk.

"The earn-out model is in vogue," said Mr Amit Singh, Assistant Vice-President, Avendus Advisors. "We see more number of deals being structured on this model," Mr Singh said, adding that many buyers, especially in the IT sector where valuations are usually high, prefer to derisk themselves by linking the valuations to earn-outs.

Derisking strategy

"Earn-outs represent skin-in-the-game on the part of the sellers," said Mr Sudip Nandy, Chief Strategy Officer, Wipro Technologies. Two of the three deals (NewLogic and cMango) that Wipro concluded recently were structured on the earn-out model.

"In cases of stock transactions, the seller takes the risk of appreciation of the purchaser's stock. For the purchaser, earn-outs help bridge valuation expectation gaps and also reduce the amount of upfront payment. Lastly, the `earn as you perform' model is usually more easily justifiable from an IRR (internal rate of return) perspective," he added.

Earn-outs are more common with front-end acquisitions, i.e., those with a market facing capability enhancement, compared to back-end acquisitions, in which the purchaser acquires a new delivery capability.

However, Mr Nandy said he believed earn-outs are not a trend but based on the nature of the deal. The deals that are of aggregation or consolidation type in nature do not have earn-outs. However, if the deals are executed with a view to realising synergy benefits and expected to be revenue- and growth-accretive, then they tend to be earn-out based.

"This is so particularly when the overlaps are less; which means that if a deal is significantly complementary in nature, it tends to be earn-out based."

Further, Mr Singh said, from a seller's perspective the model makes sense because they can demand a higher valuation linked to future performance and may be even reap the benefits of the potential synergy between the engaging parties.

Retention tool

"It also acts as a great employee/promoter retention tool. This is of critical significance in a people-oriented industry like the IT industry."

According to Mr Nandy, the model also gives the purchaser more time to learn the ropes and derisk the acquired business. "Keeping too large an earn-out, however, may not just ensure retention; it may convert team-player into a turf-player. So, earn-outs in moderation tend to benefit both the seller and the purchaser in the long term."

Mr Girish Wardadkar, President and Executive Director of KPIT Cummins Infosystems Ltd, said that earn-out based deals also help close any open issues that remain in any such acquisition. "It also helps as some kind of insurance on future success," he added.

Two of the three deals that KPIT Cummins signed recently - CG Smith Software and SolvCentral.com - were structured on the earn-out model.

However, Mr Singh said that from an integration perspective it might not be a great idea to have earn-outs spread over a long period of time, unless the objective were to keep the acquired company as a separate business entity. So, most deals have earn-out periods of less than or equal to two years.

More Stories on : Software | Mergers & Acquisitions

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