Creating Earnout Agreements that Work
The use of earnout agreements to acquire companies continues to be a favorite way for buyers to limit up-front cash, share the risk in the acquired company’s future financial performance, and engage the seller in continuing as an employee to help reach deal objectives.
As with any deal, the buyer and seller have multiple things to consider.
Buyer Considerations
1. The expected revenue and profit growth rate of the business. If basing the deal valuation on a 25% annual growth for five years, the buyer will likely request a more substantial contingent payment (e.g., earnout) provision. Terms will vary but could be 40%-60% in cash or equity at close and as much as 60% earned and paid over three years. While the buyer may want to tie the seller up for five years to match the expected growth period, there are reasons a long term is problematic. We’ll cover those in the remaining considerations.
2. Deciding who’s in charge. Some buyers allow the seller to maintain his autonomy and run the acquired business as a stand-alone entity. This happens most commonly in a financial transaction rather than a strategic one. In a financial deal, the entity’s economic strength, brand equity, management talent, and industry are unique or stable and provide acceptable returns to the buyer.
In a strategic acquisition, the sum of the parts is expected to create a stronger combined company with the capture of new market segments and niche expansion. Furthermore, cost savings from shared services for finance, treasury, HR, IT, communications, and legal processes; and merging sales forces, add to the list of value drivers.
In both deal types, establishing clear accountabilities, role clarity, and expectations during the negotiations is beneficial to all parties. There is no scenario in which nothing changes, so deciding who’s in charge will save time, money, and headaches later.
3. What happens on day one? Too many buyers complete a due diligence checklist that ends on the closing date of the sale, leaving its leaders to handle the post-acquisition period in the ordinary course of business. This approach significantly increases the transition period risks, including the odds of reaching long-term deal targets. There are many reasons that 75% of deals don’t deliver expected results. Not planning beyond the closing date is a meaningful driver.
There may be reasons to leave the acquired company alone to do their thing. It will be the preference of most sellers. In most cases, this is a mistake. Whether the question surrounds names on buildings, branding decisions, marketing approaches, sales team integration, compensation/benefits planning, decision-making rights, customer care, communication processes, choice of back office platforms, or collaboration apps, the companies that leave this to chance or a post-earnout period change usually regret that decision.
By not making clear decisions at the beginning, we create inherent conflicts. Processes which worked well in the separate companies, collide to produce employee and customer confusion. It’s one thing to put employees through an internal struggle (although in a world of 65% employee disengagement, I’m not sure why we would). It’s another to make it harder for customers to do business with us.
4. The people added to the team and the ones leaving. In the bright lights of a deal, people matters are sometimes glossed over by the glow and excitement on both sides of the table. Both buyers and sellers do this to their detriment. If there is no earnout and both parties go their separate ways on closing day, the concern for the buyer is whether due diligence uncovered all material issues and the seller’s executives and owners told the truth about the company.
If there is an earnout, those concerns remain to a degree. Adding to the list are questions about whether the remaining executive team and key employees will stay and contribute, embrace and help build a single culture, efficiently sell to grow the business, continue the behaviors that created their company in the first place, and not retire in place before the earnout period ends.
5. What happens after the earnout? This seems like a premature question at the front end, but it’s worth spending some time considering. The known quantity is that we are purchasing a company for the long-term that we expect to grow for the next five years. We are locking up key talent from the seller for three years. We may plan to transfer the knowledge from the seller’s people during the first three years to reduce the risk.
We may fall in love with each other, but those odds are equivalent to spotting a chupacabra. It’s natural to be optimistic about a long-term relationship, but it’s prudent to have contingencies for falling out of love. Entrepreneurs who’ve called their shots have mixed emotions about being part of a more prominent company. A two or three-year earnout period may seem acceptable until the seller starts feeling like a prisoner in the new company and he begins drawing lines on a wall to mark his days.
The strong recommendation is to hope for a long-term relationship and plan for a short-term one. There are too many variables in play to bet on retaining more than 25% of the seller’s team over time, and less for those employees that shared in the sale proceeds.
6. Crafting an agreement that balances incentives and complexity. A buyer uses earnout agreements to reduce cash outlay, spread risk over time, share risk with the seller, or improve the capabilities of the existing team. There is an expectation of revenue and profit growth inherent in the valuation. The hope is that the seller brings knowledge and experience to the transaction that helps the combined companies achieve that growth.
It follows that earnouts commonly link to revenue growth, customer growth, and profitability (e.g., EBITDA) during the earnout period. Buyers should resist the temptation to do two things: 1. Add multiple weighted measures to calculate earnout payments 2. Use subjective measures that may be debated by the parties. During the negotiations, choose metrics that indicate and measure value creation without debate starting on day one. Agree on the metrics and include detailed descriptions and calculation methods in the purchase agreement.
Seller Considerations
1. Understand the buyer. All six buyer considerations above impact the seller’s assessment of deal attractiveness. If you are the seller, read each item through your lens to help prepare for the process.
2. Why are we selling the company? There are numerous reasons to sell. The list includes liquidity needs, retirement, strategic growth, access to intellectual property, desire to be part of a more significant entity, and so on. As the owner, your reasons for selling drive the desired deal structure as well as the kind of company to which you sell. If you are leaving on closing day, then the decisions fall mainly to price, terms, and impact on the people that have helped you build the business. If you are staying, the list expands to include the implications of working for someone else, your well-being, and wealth creation.
3. To what kind of people are we selling? Whether concerned for your employees impacted by the sale or your preferences and requirements when working for somebody else, this is an important question to ask and answer. This area of due diligence requires the seller’s full attention. For example, if the buyer is a private equity firm and your business becomes a portfolio company, the PE will offer the names of existing portfolio company CEOs as references. Call them and ask questions. But then ask for the names and numbers of the CEOs that led portfolio companies that were closed or sold to get another perspective. You may well find a different point of view from leaders no longer affiliated with the PE. If the buyer is another company, it’s useful to understand your new boss’ style and reputation in his current business and with previous employers.
As previously noted, while you may be staying on for as little as six months and you believe you can do that standing on your head, realizing you’ve sold to the wrong party or at the incorrect terms shortly after closing is a special hell to avoid.
4. Why is the buyer interested in our company? Understanding a buyer’s motives provides essential context for negotiations. It also helps you evaluate the attractiveness of an earnout agreement and related service period.
5. How long should the earnout period be? The shorter, the better. Most buyers would prefer 100% cash or equity at closing. If an earnout is in play, a shorter period is preferable with milestones (i.e., metrics/measures) the seller can control. For example, if the seller is a rainmaker and revenue-generating machine, using customer or revenue growth as a metric is desirable. If the buyer wants to use level of operations process integration as a measure, the seller will, by definition, have less control over how quickly and efficiently that can be done due to the complexity and number of people involved in such an effort.
6. What incentives will keep me engaged? If an earnout is part of the deal, think through the sort of motivation that keeps you engaged. If joining a larger company that is public or pre-IPO, you may push for equity given the potential multiplier each dollar of profit drives over time. If you are an inventor, having access to an engineering team and studio may be the ticket. Whatever is important to you from a financial perspective, work with a tax adviser and take the time to structure an earnout that works for you. Again, you don’t want to be the former owner making marks on the wall to count the days remaining in your sentence.
7. What happens if there is a change of control during the earnout period? If a third party acquires the buyer during the original seller’s earnout period, the new owner will usually be assigned the rights and obligations of the original purchase agreement. With that said, depending on the buyer, many of the conditions the original seller considered and accepted may change under new ownership.
To the extent possible, the seller should consider a single-trigger or double-trigger clause in the sale agreement. A single-trigger may be a change in control of the buyer, allowing the seller to accelerate consideration paid to him and ending his obligations. A savvy buyer would not let single-trigger language stand in most cases. The seller is more likely to be successful in getting double-trigger event language in the agreement. In this scenario, the first trigger is the change of control of the original buyer and the second trigger is the seller’s employment being terminated by the new owner. This may seem like an outlier, but it happens.
Takeaway: Understanding both sides of a deal helps set expectations and create a balanced negotiation which reduces the chances of deal remorse. Most importantly, setting the inevitable emotions of deal-making aside helps prepare us for day one and beyond. Earnouts aren’t going away, so making sure we structure them to increase the chances of a successful outcome makes sense for all parties.
