Thinking about entering an earn-out agreement? Here's an insider's look into what perks and challenges may lie ahead.
A WORD OF CAUTION Realize your business life is going to be different as a division of a big company; you can no longer make decisions unilaterally.
When a big company buys a little one, the deal is usually concealed behind confidentiality agreements, which makes it hard to get the details.
Recently I spent the weekend with a friend of mine who leads corporate development for a billion-dollar company. His job is to manage a team that buys small companies and tries to integrate them into the mother ship. He estimates his team has led a dozen or so acquisitions in the last two years.
Providing a rare and candid glimpse inside the mind of an acquirer, my friend agreed to speak with me–on the condition of anonymity–about the typical deal, and why some work and others don’t.
Can you outline the typical formula you use to buy a company? We try to limit our risk as much as possible by putting a significant portion of the deal in an earn-out, which we only pay if the entrepreneur meets the objectives we set for them.
What do you mean by 'significant'? At least half.
So how do you structure the earn-out payments? We agree to a set of revenue and EBITDA targets over a three-year period and then reward the owner(s) for hitting their plan. We typically put fifty percent of the value of the earn-out in year three; thirty percent in year two; and twenty percent for hitting the first year's plan.
What percentage of the owners last for the full length of their earn-out? Most stick it out because such a lot of money is at stake. But it can get acrimonious.
What kinds of issues come up during the earn-out? Typically it comes down to how we, at headquarters, make decisions that affect individual operating units. For example, we charge the P&L of each of our business units with a variety of expenses that can drag down the profitability of an individual business unit.
What else goes wrong? It often comes down to the soft issues. Our CEO takes the position that he has just cut a big cheque and expects the founder(s) to make an effort to be a team player. The entrepreneurs usually take the position that they have just left a lot of money on the table in an earn-out and they expect the company to do the work to make the new relationship gel. Both parties think the other should be making the majority of the effort, and it can be a recipe for problems.
What happens when things go wrong? In the worst case scenario, the company we have bought does not integrate and essentially runs as its own business. Every conversation with the founder(s) starts with them asking the question, "How is this going to affect my earn-out?"
If there are so many issues with an earn-out, why do you still use them as the primary formula for acquiring a company? Our CEO used to be our CFO. He's in his early sixties and this will be his last big job. He's a numbers guy and he thinks first and foremost about risk avoidance. If it comes down to pursuing an opportunity or avoiding a risk, he’ll choose risk avoidance ten times out of ten.
Isn't it a problem if your acquisitions fail to integrate? Yes, it's a major problem. We're batting five hundred right now–for every success we have at least one failure.
So what advice would you have for a business owner considering an offer from an acquirer? First off, I think the standard three-year earn-out is too long. We still use it, but by the third year everyone is ready to move on. I'm trying to get our company to move to a two-year earn-out.
What else would you caution business owners about? Realize your business life is going to be different as a division of a big company; you can no longer make decisions unilaterally. You have to get used to working as a member of a team and occasionally putting the team's needs ahead of your own. Finally, before you agree to anything, ask the acquirer what the company is prepared to do to help you hit your objectives. Challenge them and listen hard to what they commit to. Based on how they answer this question, you can predict a lot about what life will be like after an acquisition.