How to Structure an Earn-out

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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

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Christine Lagorio 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 executive editor of Inc.com. @Lagorio