Defining an earnout is almost always the most complex and potentially contentious element of a transaction.
The reason is because it is a collision of concepts and expectations that can vary dramatically between the seller and the buyer.
The key concepts are
Strategy – Risk - Timing – Value - Control
It is very likely that the buyer and seller will start on complete opposite ends of the continuum on each of these attributes.
Not every time though. If there has been tremendous harmony throughout the offering process AND the seller is very confident about the buyer’s ability to perform after closing, the two parties might be able to land on an outcome that balances all five of those attributes.
This narrative assumes a 100% sale. It becomes even far more complex to establish when a partial sale and a required future role is involved.
Let’s analyze each of the five key attributes.
Strategy
In most situations the seller wants the most possible cash at closing and the buyer wants to use the least amount of cash possible. There are buyers that will propose absurd acquisition models such as 25% cash at close and 75% in a (contingent) earnout. As a firm we dismiss these proposals immediately.
The key word here is contingent. Earnouts are not guaranteed. A lot of things have to go right in order for an earnout to actually get funded.
Critical Note – we always recommend that earnouts be predicated upon revenue and not net income or EBITDA. The reason is that accounting can be very subjective and self-serving.
Example, the company being acquired may be included in a shared services model. That means it does not have its own sales, marketing, accounting, HR, payroll etc. Shared services are then “allocated” to the operating entities.
This allocation is inversely proportional to an earnout calculated on the final income number.
The higher the shared services allocation expense the lower the earnout income number. This concept has been manipulated since the stone age. I once stared down the CEO of a seven-billion-dollar company. He wanted me to allocate 90% of the shared services to company A when 67% was the correct percentage. I could not ethically follow his directive and I stood up and told him that I would not do it. I ultimately got a full year’s severance and did not compromise my ethics.
This is another example of where the seller needs a very astute and experienced M&A advisor to represent his or her best interests.
The seller and advisor should fully discuss and develop their earnout strategy prior to commencing an offering. This strategy should include prospective economic parameters and timeframes.
Risk
There is no risk in cash. The seller takes it at closing and has total investment control going forward. There is always a lot of risk with an earnout.
- The buyer could drive the combined company into the ground
- Key management and employees could depart
- Major customers could be lost
- Market changes destroy operating margins
- Huge cultural clash between the combining entities
The buyer has a lot less risk if they put a lot less cash into the deal at closing. Under an earnout they only pay for known achieved results. When you see it in print it resonates that an earnout is potentially fair to a buyer. Should the buyer take all of the risk at closing and going forward?
Disclosure - the key is to balance the risk. I only represent sellers so I tend to be risk averse on behalf of my sellers.
The risk varies completely depending upon the specific deal circumstances.
Buyer Minimum Price 10,000,000.
Example 1 - Sale to Apple – 10,000,000 at close and an earnout target up to 10,000,000. Great Deal. Take it. Very low risk and tremendous upside over minimum price.
Example 2 – Sale to Quality Buyer – 10,000,000 at close and earnout target up to 3,000,000. Very favorable with moderate risk and substantial upside over minimum price.
Example 3 – Sale to Uncertain Buyer – 5,000,000 at close and an earnout target up to 5,000,000. Very unfavorable with high risk of not achieving the minimum price.
The seller and M&A advisor need to do a very detailed assessment of the buyer and their likelihood of achieving the earnout parameters.
Timing
Time is always the number one enemy of deals. It is often times the enemy of earnouts too. There is a huge difference between a two-year earnout - a three-year earnout and a five-year earnout. If everything works gloriously the seller will typically make the most money under the five-year earnout if it pays at the end of each of the five years.
Conversely, the number of unknowns and unpredictability goes up exponentially from a two-year window to a five-year window. Even with everything that you know about the buyer there can be a lot of evolving unexpected changes over a five-year period. As a firm we never encourage our sellers to go out beyond three years.
Value
How much of the purchase price should be put at risk with an earnout?
There is no single right answer to this one. It should be circumstance driven.
In a perfect model I strive to achieve 100% of my clients minimum required purchase price as part of the base deal. In that case all of the potential earnout dollars are upside.
When that is not attainable it becomes a seller decision as to what they can live with.
It also depends upon how many offers are on the table. We work diligently to get our clients at least five offers to choose from.
What should a seller take if their minimum price is 10,000,000?
- Offer 1 – 10,000,000 cash at closing and 2,000,000 earnout
- Offer 2 - 8,000,000 cash at closing and 6,000,000 earnout
- Offer 3 - 6,000,000 cash at closing and 10,000,000 earnout
See where the teaser and the fool’s gold comes in?
I am conservative and will always lean towards Offer 1 (unless it is Apple from the example above). It gets the seller 100% of their minimum offer and a potential 20% overage.
It is hard to have seller’s remorse when you get 100% of the minimum price that you wanted.
Conversely, if you only end up with 80% or 60% you might have a lot of remorse.
Always keep in mind that the earnouts are not guaranteed!
Control
This is the big wild card that should make the decision clearer.
You won’t be in control for the very first time. Someone that you hardly know will be at the helm of your beloved company. Worse yet. Your company has to go through a transition to a new leader and potentially an assimilation into a completely new operating environment.
All of this change and disruption alone could harm earnings. Then you have to question whether the new leadership can operate the company as well as you did. You may have committed to a short transition period or even a lengthier participation period, but either way you are NO LONGER IN CHARGE.
Is this a lot different than betting on a horse at the track? In both cases you studied and made an informed decision. However, the future is incredibly unpredictable.
At the end of the day this is your decision and yours alone. You might have been a risk taker all along but that was when you were betting on yourself.
Think long and hard on this one and ask yourself one question. Am I being prudent or am I being greedy?
Happy Deciding!