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Valuation Principles and Working with Earnouts

“During negotiations, the seller would want the earnout to be based on revenue, as it's the most controllable number, while buyers would prefer an EBITDA-based earnout since it's closer to value.” - PJ Patel

Deals and even negotiations can’t be done without a proper company valuation. Valuation is a fundamental process that helps determine the true worth of a company, providing a solid foundation for negotiations between parties. But valuations are not always objective, and there are a lot of factors that can impact them. In this episode, PJ Patel, Co-CEO & Senior Managing Director at Valuation Research Corporation (VRC), discusses current valuation trends and working with earnouts.

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PJ Patel

PJ Patel is the Co-CEO and Senior Managing Director at Valuation Research Corporation (VRC). He leads VRC’s financial reporting practice, is a frequent presenter on valuation issues, and recently spoke at the Financial Accounting Standards Board roundtable to discuss how goodwill is valued.

Episode Transcript

Market Trends

Well, it's an interesting time. I was talking to somebody in my network recently and they were saying they've never seen such diverse opinions on where the economy is going. 

Where's inflation going? Where are interest rates going? As a result of that, you see the impact in the stock market in the valuations of companies, both public and private. So there's a lot of uncertainty in the market, I would say.

It does feel as though, in the next six months or less, we should have more clarity on the market and where we're going. But there's always something. I've been doing valuation for over 25 years, there's always some reason for concern. There's always some reason to wonder if we're at the top or bottom of the market or how long we will continue to go sideways. So there are always things to talk about, which makes it very interesting. It's been a phenomenal ride for 25 years, but there's always something.

Valuation on Tech companies

There are two things there. First, on the tech side, we saw through the pandemic that maybe the world has changed and tech, where you don't necessarily have the same kind of in-person interactions, is the way to go. Many companies hired to support growth in their valuation and demand. Now, there might be a reset. Valuations are still higher than where they were three years ago, but not as high as they were during the pandemic.

Regarding other valuations, there's definitely a movement to quality. If you've got a good company with good fundamentals and management, you're going to get a premium and continue to get a premium. On the other hand, if you're not that game player in your market, you might not get that kind of premium. For a while, all companies seemed to have a premium associated with them, but that's gone away. So, it really depends on where you are in the market, and there is an emphasis on quality right now.

I believe it's a little bit of everything. Over time, I have seen that investors seem to move as a group, as a herd, into different areas. Tech, for instance, during the pandemic. Throughout my career, I've seen other industries where investors seem to move as a group into and then out of, causing dramatic shifts in supply and demand, and as a result, significant shifts in price.

Maximizing your company's valuation

Right now, it's about cash flow and earnings, with EBITDA as a good indicator of cash flow. At different times, it can be different things. In the past two years, it may have been more about growth and revenue growth, for example, or users. However, cash is king, and being positive from an EBITDA perspective is always good. Having growth from an EBITDA perspective is really good.

Although, at times, we've seen periods like the dot-com era in the late nineties or, more recently, through the pandemic, where there can be an emphasis on something other than cash flow or something in addition to cash flow. This may result in a lot of enthusiasm in terms of people getting into one space or another.

Growth vs. Cash flow

There is never any right answer. In our roles, we figure out where to put our resources. That's a big part of your role, and I know it's a big part of my role as well. There is a scarcity in resources, and it's about how you apply them. In certain environments, there's a huge opportunity in front of us, so let's put the money into growth. At other times, let's watch our pennies, be more pragmatic on where we're spending, and focus on profitability. I hate to say this, but it depends. 

Generally speaking, the pendulum switched from pure top-line growth to profitability. Cash is king, and if you have a positive EBITDA, that's good. If you've got growth in EBITDA, that's a good thing. But if there's a potential for more growth and EBIDTA, great. In some ways, that's the flight to quality that I talked about earlier.

The Effect of Storytelling on Valuations

Yes, you do need to be able to tell the story, and the story needs to be consistent, effective, and efficient in getting people excited about the place you want to be. There is also an element of being in the right place at the right time. For example, the recent crypto-related bankruptcy showed that some of those folks were just in the right spot at the right time, with a lot of enthusiasm and fear of missing out from an investor perspective.

Creating demand through storytelling is important, but if you're in an area that's maybe not quite as appealing, even if you're a great storyteller, there may not be a lot of interest. So, it's a combination of factors, like many things in life. But being able to tell a good story is important.

Investor's Influence on Valuation

Sure, especially for early-stage companies, valuations are challenging. The range of potential values is significant. If you can point to an actual market transaction where people have invested in the company, that's a fact pattern, and of course, you're going to rely on that, which is important. However, we also do a lot of work in more mature industries where valuations are easier and the range isn't quite as wide.

You're always looking for market evidence of the company's value. So you may look at recent transactions, public comps where available, and use some metric, usually EBITDA, or if they're pre-EBITDA, maybe it's revenue or something else. 

Then, you do a cash flow model, looking at what you expect from the company going forward. Certain companies are easier to project than others. If you've got an earlier-stage company, it's challenging to project, and there's a lot of risk in scaling the company. Determining whether management can scale the company is difficult.

Your ability to the story and how you project your numbers have to be consistent with each other. When we go in to talk with companies, we want to hear the story, and we will judge the people we're talking to based on the story we hear and the numbers we see. The vast majority of times, the stories align with the numbers and the people, and we feel comfortable. However, over my career, every once in a while, you walk out of a meeting and think, "This is not going to work." Either the numbers are wrong; the people are the wrong fit, or maybe both.

Anytime you're talking about valuation, you're talking about people. Can you trust them, and do you believe what they're saying? So that's an important part of what we do as we talk to management and the investing group, looking at the numbers they're projecting.

Things to avoid as an operator 

Certainly, one of the things that depend on the stage of the company is the focus. Sometimes earlier-stage companies are not focused enough. They see multiple opportunities and want to grab them all. 

Being laser-focused on who you are and what you want to focus on is crucial. Once you show that you can execute the plan and deliver the results you promised, there's an opportunity to diversify and move on to other areas. Being focused, knowing who you are, where you want to be, and how you define success is essential.

Keeping clean books is also important because the more clutter you have, the harder it is to see if you're meeting your goals and achieving what you said you would. 

Having a plan and ensuring it's reasonable, along with having the skill set and resources to execute it, is crucial. 

A lot of times, in roles like yours and mine, it's not just about us but about the entire team. You have to rely on the team around you and have a solid, trustworthy group of people to support you. Trust is an essential element in achieving success.

Common mistakes in valuation

Too much optimism is the number one mistake that I've seen in valuations. When looking at the drivers of value, such as revenue growth, margins, cash flow, and risk, there's often a tendency to have an overly optimistic view of the company's prospects.

There are many hurdles to overcome in growing a business, and some of the biggest challenges are people issues. Setbacks and problems will arise, and the individuals that help a company at its startup stage might not be the same ones that help it reach the next level.

It's essential to have a realistic understanding of whether you have the necessary pieces in place to achieve your goals. This includes being cautious with forecasts, growth projections, margins, and synergies and properly assessing risk.

It's not unusual for deal teams to present an optimistic view of a transaction, only for a more realistic assessment to emerge when working with the accounting group to test for impairment. There's often a resetting of expectations as you move from the deal team to the corporate team.


Impairment is a significant issue for public companies, especially when large sums are involved. For example, when a company is considering an acquisition, it can be similar to buying a house; they may fall in love with the target company and become overly optimistic about the potential synergies, growth, and margins, leading to an increased valuation.

However, a year after the deal is completed, companies must test for impairment to assess the acquired company's actual value compared to the value at the time of acquisition. The accounting rules mandate this process to ensure that the acquired company's assets are not overvalued on the balance sheet.

Companies need to strike a balance between enthusiasm for an acquisition and a realistic assessment of the potential value and risks involved.

Goodwill is tested at the reporting unit level, either a segment or a level just below a segment. When testing for impairment, it is not necessarily done at the acquisition level but rather at the reporting unit or segment level, depending on the company's structure.

There is often confusion surrounding the process of testing for impairment, even though the rules have been in place for over 22 years. Companies need to understand that goodwill impairment testing is conducted at the reporting unit level, which may encompass more than just the acquired company. This level could include the entire segment or another reporting unit within the company's organizational structure.

Implications of impairment 

A write-down typically involves goodwill, which represents the excess purchase price paid at the time of the transaction. While a goodwill impairment is a non-cash item and may not significantly impact the company's cash flow, it carries a reputational cost. 

Management admits that they overpaid for the acquisition, and few CEOs or CFOs want to make such an admission. Due to the potential reputational damage, a significant amount of work, analysis, and discussion is often involved in assessing potential impairments. 

Companies carefully review forecasts and other factors to ensure that if there is an impairment, it is justified and accurately reflects the current value of the company, reporting unit, or acquisition relative to the original purchase price. It's a whole another interview when it comes to taxation.  

Other considerations during valuation

For public companies, there are various aspects to consider. At the time of an acquisition, you must perform a purchase price allocation, which involves allocating the purchase price to various assets and liabilities that have been acquired.

If the acquisition involves an international or multinational deal, you may also need to allocate value to various entities worldwide for tax purposes. Subsequent to the acquisition, you may have to test for impairments, which is an important element of the process.

There are other tasks related to valuation that you might need to address. For private companies, these tasks could include valuing stock options, restricted stock, profit interests, or earnouts that were part of the deal structure. These are just a few examples of the various tasks that may need to be completed from a valuation perspective as part of a transaction or after it has been completed.

Purchase price allocation

Try to do what's right. We're specialists in coming up with values, with experts in various fields such as machinery, equipment, real estate, and intangible assets like intellectual property. Doing what's right is the best answer for everyone.

Sometimes, having more value in goodwill is beneficial, as it could result in less unamortizable or depreciable assets and lower expenses. On the other hand, there might be benefits in having more value in fixed assets. However, I have found over my career that the best thing I can do for my clients is to provide the most accurate estimate of asset values.

If you start playing the game of manipulating values, you can create problems. In today's world, there's so much scrutiny from various parties like management, auditors, SEC, and PCAOB that it's not worth it. It's better to do the right thing and focus on the long-term well-being of yourself and your clients by providing numbers that stand up to the test of time.

At VRC, we've built our reputation around taking a long-term view and doing what's right. We value assets in a way that stands up to scrutiny, and this approach has proven to be successful over time.


We're seeing a lot of deals with earnouts and have been for quite some time. This year, we might see even bigger earnouts. This is because earnouts are used to bridge the gap between buyer and seller expectations. Sellers might believe their company's value is high, while buyers might be more cautious. An earnout agreement can help bridge that difference.

Often, people prefer to keep earnout structures simple, which is good. There might be a revenue or EBITDA threshold that needs to be hit to earn the earnout. In some industries, like healthcare and pharmaceuticals, the structures can be more nuanced, with milestones based on achieving different phases in development.

Earnouts are quite popular; we see them in about 70% of the deals we work on. It wouldn't surprise me if they become even more popular as we move forward into 2023.

Earnout structures

In earnout agreements, the terms usually involve hitting specific thresholds. Another crucial aspect of an earnout is whether the seller trusts the buyer to pay the agreed amount. For example, the buyer would love to push the earnout to 5 years based on revenues or EBITDA, but does the seller really have control of those things?

So we tend to see one or two years out earnouts, with more reasonable and attainable thresholds based on the seller's effort and actions rather than the acquiring party.

Another consideration for the seller is whether they believe the buyer can pay the agreed amount. Trusting the party on the other side of the table is important. While we rarely see situations where the buyer doesn't fulfill their commitment, it's still something to keep in mind.

More often than not, buyers try to maintain a good reputation by ensuring they meet their obligations. If the seller comes close to achieving the earnout target, buyers may even bend over backwards to make the seller whole to maintain a positive relationship.

In some situations, rollover equity is used instead of an earnout. Let's just backtrack for a minute. There are different components to what the consideration looks like: you have cash upfront, earnouts, and rollover equity, where the selling shareholders now have equity in the new company. 

If the individuals at the company are critical, what better way to align their interests and ensure they still have skin in the game than by giving them equity in the new company? So we see, especially on the private equity side, many deals have rollover equity – it's a very common structure.

For example, 5 people own a hundred percent of the company. Maybe in the new structure, they now own 20% of the company going forward and the rest is owned by private equity. It's part of the deal structure and retention plan. 

Length of earnouts

From a buyer's perspective, the company's value is based on perpetual or infinite cash flows. So you want to ensure that you're protecting the company's value. So you're going to push the earnout as long as possible. 

From the seller's perspective, though, you prefer the earnout to be shorter because that's what you can control.

As for the percentage amount, typically, 80-90% of the deal is upfront cash. If you were the seller and agreed to the opposite, where 80% was in an earnout, you'd essentially be handing over the keys and still continuing to take all the risk of operating the company. Why would you be willing to do that? 

It's still a competitive deal environment. Finding good quality companies is hard, and there's a lot of competition out there with private equity and public companies all looking to do deals. Even though the market is not as good as it was a couple of years ago, it's still good. If you've got a good quality company, there are still a lot of people that are chasing you to invest. 

So it really depends on what you're comfortable with. If the seller wants to continue having a stake in a business going forward, rollover equity is ideal. On the other hand, if the seller is looking to buy a hundred percent of the company, it will be an earnout. 

We haven't seen much of the seller's note, but we might in the future. But I often wonder, If you're going to sell a company, with a really big earn or with a seller note, you haven't changed your risk profile. So why are you doing that deal? You're just handing the keys to somebody else, letting them operate the company, giving them the upside, and you still got all the downside. 

Computing for Earnouts

The vast majority of earnouts are based on revenue or EBITDA thresholds. However, every once in a while, there may be an earnout based on a company's ability to acquire one of its targets. For example, it might seem like a very low-probability event at the time, but fast forward six months, and they get the deal.

Those situations are much harder to value. We use complicated models that employ option pricing theory to assess different probabilities of events happening at some point in the future and determine the current value of those future events. 

However, when it comes to something like one company acquiring another, there's really no way to do it other than considering whether they are talking or if there is any sort of discussion in process about a deal happening. You can't use option pricing theory on something like that; it's more of a probability factor.

Suppose the target company hits this EBITDA number. In that case, we're going to apply a multiple on the difference between the projected EBITDA and this EBITDA, or just give you an X number of dollars for hitting this threshold. There are all kinds of different structures. 

If you're the seller, the top-line revenue is the most controllable number, so that's what you would want. As a buyer, you'd want EBITDA because it's closer to value. Buyers typically want the earnout period as far out as possible, while sellers want it as close as possible.

Many earnouts turn into litigation because parties may be aligned going into a deal but not necessarily after the deal. It could be as simple as selling shareholders being ready to move on to their next adventure or having differing perspectives on the business. There could also be issues with the business that were not apparent during the due diligence process. This misalignment can result in litigation, as one party may feel they were not treated fairly.

Negotiating Earnouts

Competition is good when it comes to negotiating earnouts. If you're dealing with only one party, it's hard to determine what the market range is. Having competition in the process can be beneficial. It's also important to know what's important to you, whether it's the overall valuation or the upfront payment.

If the financials don't support the desired valuation, an earnout may be the only way to bridge the gap. Understanding what's driving the earnout and whether the other party is negotiating in good faith is essential. If the reason for a significant earnout is a lack of competition, then introducing competition into the process may be helpful.

When it comes to the timeline, try to compress it as much as possible. The party with more leverage in the negotiation will have a better chance of pushing back on terms. Also, if you're in an industry that many people want to get into, you'll have more leverage to dictate your own terms.

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