The topic of earn-outs just came up in a mega-deal, so it's worth understanding.
Quick definition: and earn-out is a provision in a deal in which the buyer will pay an additional specified amount to the seller if the target company hits specified financial targets in a given period of time.
The earn-out can come in different forms, depending on the terms of the agreement. Usually, if the buyer is not entirely willing to pay the full asking price from the seller, the two sides will agree to a slightly lower price up front with an earn-out later on the condition that the target company performs, so the buyer is paying for what it gets.
Earn-outs began as mainly a private market phenomenon, but have been adopted in public markets over time.
Often, earn-outs happen over 3-year increments. Sometimes the earn-out can be a lump sum, but often, they happen in increments. Let’s say company ‘X’ is selling to company buyer ‘Y,’ and Y says to the shareholders of X it will pay a given amount over one year if Y is meeting its financial targets. Maybe if X’s earnings reports are showing that it is running at an annual rate that meets its target, Y will pay the proportional amount to X shareholders.
Recently, Nvidia (NVDA) - Get Report announced it has agreed with SoftBank to buy British chipmaker Arm Holdings for $40 billion. In the deal, there is $12 billion of cash and about $23 billion of stock. But that’s already 18 times sales for an Arm Holdings that hasn’t grown as fast as it once did. So Nvidia agreed to a $5 billion earn-out. It will pay $5 billion to SoftBank shareholders if Arm hits certain targets. Under Nvidia’s roof, Arm could certainly be an incredibly valuable asset, leveraging Nvidia’s superior technology.
To see how this impact your portfolio, watch the quick video above.