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How I Learned to Love Earn Outs

by on February 20, 2014

strangelove-bomb-drop There’s a common thought that most earn outs fail, similar to the perception that most M&A deals fail.  Everybody hates earn outs yet they happen all the time.  Why?

Earn outs

Earn outs are a great way to address the gap between offer price and asking price. According to Wikipedia, an earn out is when the seller must “earn” part of the purchase price based on the performance of the business following the acquisition. In an earn out, part of the purchase price is paid after closing based on the target company achieving certain goals.  This is essentially seller financing. It’s a great way to limit the performance risk of the target company by essentially telling the seller, “I’ll pay you what you want if you do what you say you will.”  A typical earn out takes place over a 1-3 years after closing of the acquisition and may involve anywhere from 10% to 50% of the purchase price being deferred over that period.

Control

The big issue around earn outs is control.  The seller wants the control necessary to ensure it does what it can to do what it said it would do.

Financial Based Earn outs are Hard

Most earn outs are financially based because the seller thinks they’re worth more because they want to be valued on future revenues and the buyer isn’t convinced the revenues will meet forecasts.  So an earn out is structured such that the buyer will pay extra if the seller produces the revenues it believes it can deliver. If the earn out metrics are financially based, this is really hard.  Are you measuring top line revenue or bottom line profit?  Who controls the sales team? Is the product integrated?  Are the metrics related to all products or just the acquired product? Do you integrate the technologies, products, and sales teams or do you leave them all separate until the earnout is over? Financial metric earn outs are done frequently and I’ve done them myself.  One was an international transaction, adding in another level of complexity – international financial standards.  It was complicated and difficult to monitor.  It created stress and made it difficult to align the seller’s interest with the overall vision of the combined company.  Ultimately, it was a successful outcome but not without challenges.

Non-Financial Metrics

The best way to structure an earn out is to create the metrics around issues that are not financially based, are within the control of the seller, and work for the betterment of the overall company.  Examples of this are earn out metrics around product development and integration.  I structured a transaction this way and it resulted in a win-win for both companies. The seller got the value it was looking for, the founders had control over the deliverables, and the metrics were based on product development milestones.  The buyer had control over all of the financial aspects of the work, like pricing, marketing, and product integration. In the end the buyer got the product it needed at the price it wanted and the seller got the value it was looking for and control over its work.

Decreasing Relative Valuation

The great thing about earn outs from a buyer’s perspective is that the relative pricing decreases if the seller does what it says it will.  If the earn out is financially based, the additional payout is made from the sales generated and the price paid, relative to the revenue produced, decreases.  If they’re production based the enhanced product makes it easier to sell, thereby increasing revenues.

p.s.

If you’re wondering how you build a company that you can sell for a premium in a few years, contact me to discuss the Valuation Amplification Process.

I also invite you to download the white paper and learn How to Quickly Increase Your Valuation – A Proven 5 Step Process.  http://www.therevenuegroup.net/free-offer.html

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  1. 3 Common Mistakes in M&A | Mike Rogers

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