Earn-Outs in Insurance Industry Merger and Acquisition Transactions

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

These factors can be 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 initially explained, 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.