How to Structure an Earn-out
What's the value of your business? That depends on whom you ask. Ask potential buyers, especially when they're being cautious in tough economic times, and it might not meet your expectations.
Negotiating a sale of a privately-held business is never a breeze – and it's much less so in a down market in which there is little competition among buyers to drive up the multiple. When a seller's expectations aren't being met by potential buyers, including an earn-out provision in the acquisition contract can help narrow the price-expectation divide.
A common feature of many acquisitions, an earn-out stipulates that the original owners of a business are paid for the sale of their company, following which they are contractually obligated to stay with the company through a transition period, and they are provided with the incentive to have a demonstrable effect on the company's financial performance going forward. Achieving or exceeding a certain level of performance – criteria are typically set over a period of several years – means the original owners will earn a much larger profit from the sale. For buyers, an earn-out can offer the owner protection against overpaying for a company that doesn't end up thriving or growing in the way its original owners expected. It can also smooth the period of ownership transition.
Call it an incentive; call it delayed gratification; call it a compromise. Brian Mutert, founder and CEO of San Francisco-based investment bank Stratagem, which specializes in mergers and acquisitions, says earn-outs can benefit both buyers and sellers.
"It's a way for the buyer to put some skin in the game for the seller after the deal closes, and to provide some financial incentive for them to work hard in terms of the company's business after they close the deal," he says. "In a situation where the seller might believe there is a great opportunity for future growth potential, they can take some added benefit in the transaction."
Structuring an Earn-out: Setting Realistic Expectations
When there is a gap between an owner and a potential acquirer in the perceived value of a business, it is usually caused by the expected future growth of the company. That's only natural. But as a small business owner, it's necessary to step back and ask yourself: If your expectations are higher than those of your buyer, why is that?
After all, it's commonly known that roughly three-quarters of all mergers and acquisitions fall short of the expectations that are stated when the deal is announced. And about half of all deals result in a loss of value for the buyer's shareholders. So, analyze exactly what you're optimistic about – and how much of your purchase price you're willing to risk on being successful in the future.
Being equipped with solid expectations for your businesses success over the next five years can prepare you well for negotiating an earn-out.
Consider next what portion of your asking price you'd be willing to risk – and work for in the future.
"An earn-out is a contingent payout, which essentially involves shifting some of the purchase price to be paid in the future on the realization of future earnings or some other benchmarks of success," says George Geis, an associate dean of the Executive MBA Program at UCLA's Anderson School of Management. "So the owner needs to be wiling to delay some of the price, and be aware they might never get it."
Because most earn-out clauses are tied to the company's performance (measured in sales, earnings, or some other benchmark) over a three-to-five-year period, that's the timeline you should be thinking about your company's health within before embarking on negotiations. If your company had a track-record of performing at or exceeding forecasts in the past, this fact should give you added negotiating power.
Knowing expectations is vital is because the range of earn-out terms that could be offered is vast. A buyer might agree to pay 90 percent of the total purchase price you desire upfront with the remaining 10 percent paid in stock or cash after a year of earn-out time. Alternately, the buyer might split the sale price 50/50 over five years during which time the owner must agree to stay with the company and optimize its performance.
When Disney acquired Club Penguin in 2007, for example, it paid $350 million upfront, with $350 million more promised through a series of earn-outs. For high-tech and service businesses with high-growth potential, a typical deal might include an upfront payment from an acquirer of between 60 and 80 percent, with the balance paid over time possibly as an earn-out tied to performance.
Geis estimates that, in the post-dot-com-boom era, the owners of private companies regularly have been taking between 40 and 45 percent of the total pay-out through an earn-out agreement, according to surveys. If you are embarking on a sale, you will want to make sure you know their future involvement is worthwhile – and is the best way to spend time for the money offered.
Dig Deeper: What Happens After You Sell a Business
Structuring an Earn-out: Keeping it Simple
For entrepreneurs looking for a quick sale of their business, the simple st earn-out is none at all. There are significant risks involved in any acquisition that involves future conditions – especially when the old owner is expected to come on board to work for someone else and live by their rules.
"A CEO must recognize they will not be in control of their own destiny in any part the same way they were," Mutert says. "They will have new bosses and will have to march to a new set of rules than they had to when it was their own company."
Many earn-outs depend on an extremely complicated matrix of variables and goals. This should be avoided if possible. Earn-outs are most effective as an incentive for the seller when the size of the payout is determined based upon one or two simple variables. A buyer who constructed a complicated set of goals covering earnings, customer retention, and myriad other circumstances should be challenged. These conditions might not be fully under your control should you accept the earn-out. And too many variables – especially when some are out of your hands – can make achieving your earn-out impossible, Geis says.
"What you don't want to happen to make it so they control you and that you don't make your earn-out," Geis advises sellers. "That can be that they control some marketing expenses or some other element that would change the game for you and take any control of the situation out of your hands within a year or so out."
In order to avoid spending years of your life working on a possibly unattainable goal, you'll want to enter acquisition negotiations armed with a legal counsel, as well as financial advisors, specializing in mergers and acquisitions. Instruct them to fight for a simple deal with an earn-out based on an easy-to-quantify metric, such as higher corporate revenue or an expanded client base.
The simplest earn-out might be a model newly being set by Google. The search giant's director of corporate development told the Wall Street Journal that though the company used to be "addicted to" earn-outs and milestone-based compensation, the company is now shying away from such practices. Identifying myriad benchmarks and determining fair pricing for the earn-outs proved to be just too difficult. Now, 'we tend to have pretty generous packages but they're time-based, whether in equity or cash, instead of specific milestones,' Google's David Sobota told the paper.
Aiming for simplicity is best, too, for the future relationship between a company and its new owners. With aligned incentives and clear objectives, you will have less cause for arguing – or potential legal squabbles – when it's time for your payout.
Dig Deeper: A Case Study in Managing an Earn-out Agreement
Structuring an Earn-out: Avoid Earn-out Burn-out
Just as simplicity is key, for the seller, staying true to your priorities as a business owner is equally important. Sure, if you believe strongly in your company's potential, and want to guide its success through new ownership, an earn-out might give you the opportunity to do so. But ensuring that a few key elements are in place in your agreement can greatly strengthen the new arrangement.
• Keep your key players. If other executives were integral to your company's growth and success, will your company be able to function under new ownership without them? If not, come up with deals to lock them in, too.
• Keep the length of your contract as short as possible. It sounds obvious, but you'll minimize the potential for burn-out by minimizing your time working with your new parent company. You can always renew and re-negotiate, but can't hit undo. It's that simple.
• Make sure you have control. Ensure that the contract expressly states that you will oversee any departments that will be executing on the goals and standards set forth in the earn-out. You should never allow yourself to be accountable for what you cannot control.
• Ensure that incentives are in place. You know what motivates you at work. One is seeing your business succeed, and the second is money. If you've made a lot of cash in the initial sale, it's natural to loose attachment to future goals for the company. The earn-out percentage should be high enough to keep you from losing interest, especially in the event of a setback. If you are going to commit, commit fully.
Each of these standards, which you and your buyer will negotiate, can and should be included in your earn-out agreement. To vet that document, enlist acquisition specialists on both the legal and financial front. Mutert cautions that both buyers and sellers should expect to pay top-dollar for acquisition services, though, due to the complex nature of the work.
In no case should the buyer be the only voice in determining any of these elements, though, Mutert says.
"In downstream earn-outs you have to be very, very careful," he says. "Know the people that you're dealing with on the other side of the table, and work very hard to get the incentives aligned for all of the parties."
Dig Deeper: Retaining Employees Through Acquisitions
Structuring an Earn-out: Ensure Good Chances for Success (and Avoid Disaster)
You already know the importance of laying out simple, clear-cut standards that must be met for an earn-out to pay-out. There are some additional questions both parties should consider before signing on the dotted line.
Will the acquired party have enough autonomy?
"Earn-outs tend to work well when the seller is going to continue to run pretty much as before," Geis says. To that end, a seller should get in writing the seller's commitment to leave operations largely unchanged. If certain redundancies or back-office functions are to be folded into the acquiring company, that's fine. You simply want to make sure that every part of the acquired company that can be run independently is run independently.
Is the purpose of the earn-out financial or strategic?
An earn-out can be made for purely financial reasons, or a buyer can be making a bet on the owner's ability to expand the business. You will want to know which motivation is at play—and whether it is likely to change after the deal is closed. If the acquirer keeps a respectful distance and seems to be giving you autonomy, that is a good sign.
Who is the umpire? How will progress against an earn-out's goals be evaluated?
Consider both who will be evaluating the entrepreneur's performance under new ownership, and when evaluations will take place. Is it simply at the end of the period set in the contract, or will progress be tracked quarterly? Will the earn-out be allocated piecemeal or in one lump-sum? There's no right answer, but these questions should be addressed early on in your negotiations.
What will happen in the event outside factors drastically change the outcome?
Factors in neither party's control can harm the buyer's and entrepreneur's ability to maximize the rewards pledged in an earn-out. What if your industry tanks? What if a natural disaster hits? What if your biggest client was Lehman Brothers or Bear Stearns? Make sure to create contingency plans to address the most unlikely of scenarios – especially if you're entering into a long-term earn-out deal.
Dig Deeper: Striking a Good Deal
Structuring an Earn-out: Additional Resources
What not to do:
Deals from Hell: M&A Lessons that Rise Above the Ashes by Robert F. Bruner. Wiley, 2009.
A solid textbook:
Mergers, Acquisitions, and Other Restructuring Activities: An Integrated Approach to Process, Tools, Cases, and Solutions, by Donald DePamphilis. Academic Press, 2009.
On financial and legal issues:
Mergers and Acquisitions: A Step-by-Step Legal and Practical Guide by Edwin L. Miller. Wiley, 2008.
More resources from Inc.com: How to Structure an Earn-out
CHRISTINE LAGORIO-CHAFKIN | Staff Writer | Senior Writer
Christine Lagorio-Chafkin is a writer, editor, and reporter whose work has appeared in The New York Times, The Washington Post, The San Francisco Chronicle, The Village Voice, and The Believer, among other publications. She is a senior writer at Inc.