Agriculture Sector M&A and Earnouts
As in every sector, agriculture company owners and investors often disagree on valuation when negotiating the terms of a potential company sale. This is particularly the case when a valuation is based on a company’s future cash flows, which may be very difficult to reasonably forecast given the inherent volatility of agriculture commodity prices. This uncertainty can be compounded by numerous production maturity cycle, company and agriculture sector-specific risks, such as weather.
To overcome potential deal breaking impasses that arise due to valuation issues, one possible solution is an earnout. Earnouts are often used by private equity investors in M&A deals where the future cash flows of a business are difficult to predict or, alternatively, a company’s future business results are highly dependent on the post-deal closure commitment and performance of the sellers. This has become an increasingly important issue in cross-border agriculture sector M&A, where investors may not have specific agriculture sector expertise and, even if they do, they may lack the ability to effectively manage a company’s business in what may be a new agriculture vertical or operating environment.
In simple terms, an earnout is a mechanism where the payment of a portion of the purchase price in a M&A transaction is deferred until a point in time in the future when pre-agreed financial or operating targets are met. These financial targets can be based on revenues, EBITDA, EBIT or net income. The amount of the purchase price that is deferred depends on the nature of the transaction, but factors that can affect the amount of the payment deferral are the size of the transaction, how far the parties are apart on valuation and the riskiness of future business cash flows. How far in the future the earnout mechanism is structured also varies, but many investors would likely structure the earnout period around the investor’s planned investment horizon or the occurrence of certain key future events that will have a major impact on business performance, such as the implementation of a major new production project.
There are several challenges with using earnouts for both buyers and sellers. Apart from the obvious issue that for the seller a significant portion of deal compensation may be deferred potentially for years into the future, the quick receipt of which may have been the key reason for the transaction in the first place, another issue is that both the buyer and seller can have incentives to manipulate earnout triggers to raise or lower the deal payout in a way that is not in the best overall interests of the business.
If the seller will remain in control of the business and the earnout is structured based on revenues, it may be possible for the seller to increase revenues by significantly increasing underlying costs, which helps the seller financially but may harm the overall financial performance of the business. On the other hand, if the buyer is in control of the business and the earnout trigger is based on a financial metric, it may be possible for the buyer to manipulate costs so that lesser earnouts in favor of the seller are paid. Even in situations where the seller remains in control of the business and a revenue-based earnout is used, a seller may object because factors which drive agriculture sector commodity revenues are generally not in the seller’s control.
Despite potential drawbacks, the earnout remains an important mechanism to keep in mind when the parties to an agriculture M&A deal do not agree on valuation terms. Properly structured, an earnout can help the parties share risk and, perhaps more importantly, align the interests of both the buyer and seller in the post-sale period so that both parties ultimately benefit.