Earn-outs: The Good, the Bad, and a Little More Bad
One of the many curve balls you can have thrown at you during a sale transaction might come in the form of an earn-out. The concept is not difficult – if you think your business is worth $80 million and the buyer thinks it’s worth $75 million – one way to get over this negotiating stalemate is to agree that the buyer will pay you the $5 million difference over a period of time. The acquirer pays the majority of the purchase price up front and the remainder is contingent on the future performance of the company. You can “earn” the valuation gap back. So far these seem pretty easy, right?
The practical parts of putting the earn-out in action are a little more difficult to wrap your head around.
What Are You Going to Measure?
The earn-out can be based on a number of items – usually around an income statement – like revenue, gross margin, EBITDA, or net income. They can also be measured on non-financial targets, like acquiring a certain customer or retaining employees. Picking these measurement units is very important. Things get very sticky when the units of measure are difficult to see (buyer keeps financial statements close to the vest) or control.
It’s All About Control
As a seller (and sometimes a buyer), how do you feel about a large part of the purchase price being based on elements that you can’t control? Probably not so great. Most disputes over earn-outs come from the fact that the buyer may run the business differently than the seller would.
Is it fair to measure an earn-out based on revenue growth if the buyer fired the best salesperson?
Or, a bit more nuanced scenario…
Is it fair to measure an earn-out based on growth if the buyer doesn’t invest in the business?
If the seller remains with the business and has an earn-out that is revenue based, is it fair to take on risky or low margin projects in order to simply grow revenue?
If your earn-out is based on EBITDA, is it fair if you don’t have any control over a buyer increasing the expenses of the business?
Sellers with large amounts of money at stake and the ability of a buyer to play financial games, can find this lack of control annoying and scary.
For buyers where an executive with a large earn-out sticks around, the tendency is to run the business in a way that maximizes the earn-out – not necessarily the health of the company. An earn-out can also create an impediment to cultural integration – where the selling team wants to keep things the same versus integrate and lose control of the finances or operations.
For How Long?
It is not uncommon for earn-outs to last three or even five years. Five years certainly gives a seller more runway to get the maximum payout, however the company can also change drastically over that period of time. At around three years and certainly longer, you are at risk of goal fatigue – no matter how much money is involved. Shorter is better.
Should I Use One?
The short answer is probably not if you can help it. If you run a competitive investment banking process, you can usually drive value that is paid all up-front. Earn-outs look very unattractive when compared to other offers that provide cash at closing. If you are in a situation where this is the only way to move your transaction forward, make sure you follow some simple rules:
1. Keep the measurement metric as high up on the income statement as possible – revenue is best, gross profit is good. The higher up on the income statement, the less (but not zero) ability there is to manipulate the numbers
2. Keep the timeline as short as possible
3. Make sure that there is a requirement allowing the seller to see, review, and ask questions about the financial statements used to calculate the earn-out
4. Try to keep the measurement metrics as stand-alone as possible during the term of the earn-out