Expert Commentary

Earn-Outs in Insurance Industry Merger and Acquisition Transactions

The purpose of this article is to provide an overview of earn-outs and why they are used, as well as examine key metrics utilized in the insurance industry to set earn-out targets. While the topic of earn-outs can be relevant in many contexts—acquisition disputes, economic damages calculations, and complying with financial accounting rules—the scope of this article is focused specifically on the popularity of earn-outs in connection with acquisitions. The article visits components of purchase considerations as well as the factors buyers and sellers typically consider in negotiating earn-out provisions. Finally, I provide several examples of ways to structure earn-outs.


Valuation of Insurance Organizations
February 2015

An earn-out is an agreement between a buyer and seller for a contingent payment, paid by the buyer to the seller, when the seller meets certain financial or nonfinancial targets after the sale.1 An earn-out allows a buyer to lessen the risk that comes with an acquisition, while allowing a seller to achieve higher consideration based on future performance. A well planned earn-out can lead the seller to obtain a higher purchase price, capturing value from growth expectations of the target, while the buyer is able to (hopefully) ensure strong performance from the target post-transaction.

Earn-outs may bridge the gap in value perception between the buyer and seller. They are typically used whenever the seller believes the business to be sold has significant potential for future growth and success. However, with approximately three-fourths of all mergers and acquisitions not meeting future expectations,2 many buyers are reluctant to place a higher value on future earnings when valuing a target. An earn-out is a popular way to hedge a buyer's risk of paying too much for a business while allowing the seller to participate in the upside.3

Key Metrics

The buyer and seller will need to decide what target metric will be considered when determining earn-out goals. These benchmarks can be financial or nonfinancial and can relate to the entire company or a single business line.4 It is important for a buyer and seller to consider what metric will provide the best measure of the value for the business, all while balancing the risks of interpretation and realization.

For financial benchmarks, one option is to use earnings before interest, taxes, depreciation, and amortization (EBITDA), revenue growth, or gross profit margins in order to measure earn-out performance.5 The earn-out needs to be aligned with the buyer's strategic return on investment objectives. For example, if an earn-out target is based upon revenues, but the increased sales do no translate to higher earnings, the earn-out payment may be dilutive to the buyer.6 Additionally, for service companies like insurance agencies, earn-out metrics can be used to ensure that important relationships for the company being acquired are maintained after the transaction.7 This can be achieved by using metrics such as policy renewals or net retained commission targets.

Another aspect to consider when structuring an earn-out provision is what accounting principles should be used when calculating the metric. It is important to decide during the negotiations whether or not the parties will consider certain deductions, including returns, allowances, taxes, depreciation, and certain other one-time or nonrecurring costs. EBITDA is the most commonly used target in an earn-out and is preferred among most buyers, as EBITDA factors in operational costs, while still excluding nonoperational costs.8 Accordingly, an EBITDA metric is a good proxy for cash flow and easy to measure and compare with other companies or industry statistics. However, precision must be used in defining what deductions are permitted, such as corporate overhead allocations. Because of these difficulties and possible areas for disagreement post-acquisition, some transactions may base the earn-out simply on the percentage of the book(s) of business maintained or grown.

Nonfinancial metrics can also be used as an earn-out metric, such as the completion of a project or reaching a technical milestone. Additionally, it is possible to have multiple performance targets, each associated with different payout amounts. Regardless of whether using a financial or nonfinancial metric to measure the earn-out, the objective must be clearly defined and (easily, hopefully) measureable.

Considerations to Buyers and Sellers

In exchange for the contingency payments, a seller will agree to receive a lower upfront purchase price, with the expectation that potential upside of the business will be captured from the earn-out. The payment of an earn-out is typically in company stock or cash and ranges from 10 to 30 percent of the initial purchase price.9 In 2013, it was found that 40 percent of potential proceeds from a purchase were represented by earn-outs, an increase from the previous average of 23 percent from just 3 years prior.10

One of the first factors to consider is the length of time the earn-out should cover. Time periods for earn-outs typically range from 1 to 5 years.11 The time period of an earn-out can potentially cause differences in goals for the buyer and seller. A long-term earn-out may not always be practical but can help a buyer rely on the seller's support for a longer period of time, allowing a greater focus on long-term objectives as opposed to short-term growth. The longer time period can also reduce the likelihood of short-term extraordinary events affecting the ultimate total payout amount. Shorter terms sometimes cause the focus to be solely on instant results and not on the quality of the products or services and how to sustain long‑term success. Accordingly, the proper time period must be agreed upon between the buyer and seller.

Several other factors go into making earn-out payment decisions. The buyer and seller must decide the frequency of the payments, whether the earn-out is cumulative or based on some trailing average, what happens when earn-out metrics are not met every period, and whether the earn-out is paid in a lump-sum or over several periods. Sometimes, the buyer and seller will want to have an earn-out floor or cap to help structure the payouts.

In many circumstances, after the transaction, the seller will work for a company that it no longer controls, risking the performance of the company based on the decisions of the buyer. Because of the risk of the seller and buyer having competing goals, the seller will typically stay involved in the business operations throughout the earn-out period. Many buyers will allow the management team of the seller to continue to have ownership in the company or assist with the operations in order to reach a common goal of driving growth and profitability after the sale. The seller may also be concerned as to whether or not the buyer makes decisions that could impact earnings in a negative way, such as having high expenditures for a research and development project spanning several years.

To ensure the business stays relatively consistent with prior operations, a seller may negotiate covenants to the agreement in order to discourage the buyer from incurring additional debt, cutting certain product lines, changing management, or other factors.12 Many sellers believe that the business should be run without any limitations from the buyers but will agree to sign a provision stating that the buyer has complete control of the business, as long as there is nothing being done to intentionally miss the earn-out metrics.

Transactions

The factors discussed above are illustrated with recent transactions in the insurance industry. For example, United Insurance Holdings Corp., a property and casualty insurance holding company, announced in December 2014 that it entered into an agreement and plan of merger with Family Security Holdings LLC (FSIC), also an insurance holding company. The agreement included contingent consideration of 3.0 percent of all gross premiums written on the renewal of FSIC policies in place as of the closing of the transaction during the subsequent 12-month period following the closing of the transaction. The contingent consideration was paid in the form of additional shares of the buyer's stock. As discussed previously, this earn-out ensures that important customer relationships were maintained that benefit both the buyer and seller.13

Another example involving an insurance company acquiring operational assets from insurance-related businesses shows the limitations and considerations made by both the buyer and seller. The key terms of the acquisition included a guaranteed payment at closing of $19 million along with contingent earn-out payments. These contingent payments included three annual installments based on a weighted combination of revenue and EBITDA growth. The agreement between the two companies included several limitations. The payments were not to exceed $10 million per year, and there would be no payment for a given year if the average revenue and EBITDA growth was less than or equal to 17 percent. The final stipulation was that the total purchase price was not to exceed $40 million. In this transaction, the companies carefully outlined the earn-out contingencies, providing needed flexibility for both the buyer and seller to participate in the transaction.

Conclusion

When looking at the impact of earn-outs, it is important to consider the details of the agreement, as many earn-outs can be the subject of disputes. The buyer and seller should take into account the timing of cash flows from the earn-out, as well as the expectations of reaching the financial metrics agreed upon in the earn-out agreement. The earn-out targets should be easily measurable and difficult to manipulate. Finally, potential conflicts of interest between the buyer and seller should be identified and addressed in the earn-out agreement.


1Kevin Levy, Angelo Bonvino, and Prem Amarnani, "Return of the Earnout: An Important Tool for Acquisitions in Today's Economy," Business Law Today, American Bar Association (June 2011).

2Christine Lagorio-Chafkin, "How to Structure an Earn-out."

3Michael Sheldon, "Earn-Outs and Contingent Payments," Business Owner's Playbook.

4Kevin Levy, Angelo Bonvino, and Prem Amarnani, "Return of the Earnout: An Important Tool for Acquisitions in Today's Economy," Business Law Today, American Bar Association (June 2011).

5Kevin Levy, Angelo Bonvino, and Prem Amarnani, "Return of the Earnout: An Important Tool for Acquisitions in Today's Economy," Business Law Today, American Bar Association (June 2011).

6Mary Josephs, "Exit Strategies: How to Avoid Troublesome Earn-Out Problems," Forbes (Aug. 19, 2014).

7Also, covenants not to compete or solicit may also be used to protect a buyer's interest in ensuring the book of business being acquired is maintained.

8Paul Crimmins, Ben Gray, and Jessie Waller, "Earnouts in M&A Transactions," Mayer Brown (June 22, 2011).

9Jane Meggit, "What is an Earn Out Agreement," The Houston Chronicle.

10Mary Josephs, "Exit Strategies: How to Avoid Troublesome Earn-Out Problems," Forbes (Aug. 19, 2014).

11David M. Grinberg, Maryann A. Waryjas, Scott P. George, and Bernard I. Zaia, "Negotiating Earnout Provisions in M&A Deals," Stafford (July 14, 2009).

12Paul Crimmins, Ben Gray, and Jessie Waller, "Earnouts in M&A Transactions," Mayer Brown (June 22, 2011).

13"United Insurance Holdings Corp. to Acquire Family Security Holdings, LLC and Subsidiaries," BusinessWire (Dec. 15, 2014).


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

Like This Article?

IRMI Update

Dive into thought-provoking industry commentary every other week, including links to free articles from industry experts. Discover practical risk management tips, insight on important case law and be the first to receive important news regarding IRMI products and events.

Learn More



Register for CRC
Register now for AgriCon Des Moines
Featured Video
 

Featured Products

Quality Risk Management Fieldbook

Quality Risk Management Fieldbook

This step-by-step guide is not a textbook but is the perfect resource if you lead a small business, nonprofit, government entity, or political subdivision and do not have risk management expertise or staff. Everything is included to help you work alongside your insurance agent to protect and preserve your organization. Learn more.

IRMI Glossary of Insurance and Risk Management Terms

Glossary of Insurance and Risk Management Terms

This best-seller from IRMI gives you quick answers to questions involving unfamiliar insurance terminology. The definitions are written in plain English with a focus on practical application. Learn more.

Navigation

Social Media

User ID: Subscriber Status:Free