Earn-outs in Debt Restructuring Plans: Economics and Valuation

This topic is of particular relevance within the more general issue of troubled debt restructuring and option pricing methodologies. In general terms, earnouts are linked to the company’s performance. They are often structured as long-term long or short options (often, European call options) in which the underlying option is related to certain financial margins, ratios, or cash flows (revenues, EBITDA, operational cash flows, free cash flow, return on investments, or return on assets). This chapter first aims to provide insight into the rationale behind earnout provisions for financially distressed firms that agree upon debt restructuring plans with creditors. Moreover, the study investigates the basic principles of the economic valuation of earnouts. After discussing the main implications of earnout value estimation in the light of the existing literature on corporate restructuring and option pricing-related issues, we propose a valuation methodology based on a Monte Carlo simulation approach which allows the representation of a variety of projections of a few relevant financial variables, along with the related probability distribution. Besides obtaining an assessment of economic values, our model enables a probabilistic representation (not necessarily under a risk-neutral environment) of the wide spectrum of the restructured debt pay-offs, for both the company and the bank.