Earn-Outs in debt restructuring plans: economics and valuation

Outstanding academic literature mainly deals with Earn-Outs in M&As. Scarce attention has been paid to Earn-Out provisions in debt-restructuring plans. The topic is, however, of particular relevance within the more general issue of troubled debt restructuring and option pricing methodlogies. In general terms, Earn-Outs are tied to the company’s performance. They are often struc-tured as long-term long or short options (often, European call options) where the under-lying is related to certain financial margins, ratios or cash flows (revenues, EBITDA, operational cash flows, free cash flow, Return on Investments, Return on Assets). This paper first aims at providing insight to the rationale of Earn-Out provisions for fi-nancially distressed firms that agree upon some debt restructuring plans with creditors. Moreover, the work investigates the basic principles of Earn-Outs’ economic valuation. After discussing the main implications of Earn-Out value estimation at light of extant literature on corporate restructuring and option pricing related issues, we propose a valu-ation methodology based on a Monte Carlo simulation approach which allows to repre-sent a multitude of paths of a few relevant financial variables along with the related prob-ability distribution. Besides coming to an assessment of the economic values, our model allows for a probabilistic representation (not necessarily under a risk-neutral environ-ment) of the wide spectrum of the restructured debt pay-offs, for both the company and the bank.