Deal structures for acquisitions and how to use earn-outs

Deal structures and earn-outs

Since 2020 Viking Venture portfolio companies have completed almost 50 add-on acquisitions with a combined enterprise value of 7.1 bNOK. We have raised 4.7 bNOK in debt and 2.4 bNOK in equity to finance the acquisitions. Doing M&A is always challenging, and picking the right financing, and deal structure has been especially challenging in 2022. This article will share our perspectives on our portfolio’s common financing sources and deal structures. In addition, we will share our learnings from using earn-out mechanisms.

Written by: Joar Welde, Partner at Viking Venture and Jørgen Jøsok Bjørngaard, Senior Investment Associate at Viking Venture

Picking the right deal structure

M&A is a key source of growth in our portfolio. We typically acquire companies to expand our portfolio companies geographically, expand their product offering, or acquire a competitor. On average, our companies grow 42% annually, split evenly between organic and inorganic growth. Therefore, getting financing and picking the right deal structure is essential.

What do we see in the market affecting M&A?

Valuations of software companies are down more than 50% in the last 12 months. Lower valuations is caused by higher inflation, tighter monetary policies, and increased interest rates. Consequently, investors favor profitable growth, meaning companies that do not have healthy growth and profitability KPIs (Rule of 40 and positive EBITDAC in particular) are punished severely on valuation. Also, capital markets are drying up and leaving less cash on the table as activity and investor sentiment have changed. The available capital is getting very expensive. 

More challenging to secure financing for acquisitions

Publicly traded software companies have seen valuations plummet this year. For private companies, we experience a lag of 6-12 months before we see the same hit on valuations. Securing financing for acquisitions is more challenging now as valuations decrease and interest rates increase. 

Financing sources and common deal structures in our portfolio

Traditionally we see four deal structures and financing sources, often in combination:

  1. Raise equity to pay with cash
  2. Exchange shares (merger)
  3. Raise debt to pay with cash
  4. Earn-outs

Why raise equity to pay with cash?

We have raised approximately 2.4 bNOK in equity for our portfolio companies since 2020. The main advantages of this financing method are that compared to debt, it does not increase leverage, does not have to be repaid, and comes with no interest having to be paid. Still, equity is the “most expensive” financing, as the investors seek a high return on their money. Valuation discussions and raising equity could also be tough in the current market.

Why do an exchange of shares (merger)?

The main benefit of a share exchange or merger, especially in the current market conditions, is that it preserves or eliminates the need for new equity or debt. A merger could also bridge the valuation gap between buyer and seller, as the focus is on the relative valuation of the companies. The disadvantages are diluting the shareholding in the acquiring company and possibly giving away some control.

Why raise debt to pay with cash?

Debt is the cheapest form of financing, despite increasing interest rates. Suppose you manage to raise it. In our portfolio, we have used senior debt, such as bank loans and direct lending, and junior debt, such as bonds.

The disadvantages of debt are of course, that the cash flow of leveraged companies is impacted by having to pay interest. The money could have been spent on, e.g., more marketing and sales, product development, or customer service. Financial covenants such as limits on Debt /EBITDA or Debt / (EBITDA – Capital Expenditures) are typical and create risks as lenders typically require security in 100% of the shares of your company.

Deal structure and earn-outs
Jørgen Jøsok Bjørngaard, Senior Investment Associate at Viking Venture

What is an earn-out, and when do we use it?

An earn-out is a contractual mechanism that determines the final price of the acquired company based on future performance, often achieving growth in Annual Recurring Revenues (ARR). You can use earn-outs to share risk between buyer and seller, and an earn-out mechanism could also align incentives. The primary benefit of earn-outs in the current market is that it is easier to bridge the valuation gap between buyer and seller.

Learnings from the use of earn-outs

In our opinion, using an earn-out structure has significant disadvantages. 

Earn-outs must be based on KPIs specific to the acquired company, which may or may not be in line with the overall goals of the combined company. Either now or in the future. For example, an ARR-based earn-out might work well if you want increased growth. However, if times change and you need to focus on profitability, an ARR-based earn-out can be a liability. We all too often see that earn-outs need to be renegotiated, and typically, that means that you have to give full payment of the earn-out even if the KPIs are not yet met.

Future financial risk

When using an earn-out, be aware that you might be putting a considerable future financial risk on the company and future valuation, committing to raise a large amount of capital in the future. It might only be possible to raise the required amount of capital by giving investors a significant discount and destroying your company’s valuation.

Be aware of possible conflicts of interest

Earn-outs will likely put integrations on hold, as the seller is incentivized to deliver on the earn-out conditions for their own company, not on integrating the company and realizing synergies as quickly as possible. This could lead to a conflict of interest and potential disagreements. What if the acquired company fails on the earn-out? Was the seller given a fair chance to deliver on the earn-out? If not, should or should you not pay the earn-out anyway?

Earn-outs can be very tempting to bridge disagreements on price but can have unintended negative implications in the future.

Determine what is considered ARR

Setting the earn-out milestone dependent on an ARR level could also be a potential pitfall, as there are many definitions of ARR. After all, ARR is not an audited financial number. What should you include? Only subscription revenues or also support and consultancy fees? Therefore, you and the seller should agree on what is considered ARR and what is not, and a third party should determine the current and future ARR based on the agreed principles.

Finally, how to handle disagreements between buyer and seller on the earn-out condition should be addressed in the Share Purchase Agreement (SPA).

Final remarks

Doing M&A and getting financing is particularly tough in the current market, and there is no silver bullet financing or deal structure. In our opinion, good companies can be bought at a discount with good negotiations, and good companies will get funding. If you decide to use an earn-out, use it with caution and manage the process after closing.


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