Keys to Successful Earnouts
technology companies are selling early in their lives and
are becoming more prevalent. Earnouts can be a flexible technique for
bridging the price gap in an acquisition. This article discusses when
to use an earnout, traps to avoid and six rules for successful earnouts.
be versatile tools for
structuring acquisitions. An earnout may be a sensible way to bridge
the price gap between what a seller thinks his company is worth and
what the buyer is willing to pay. However, earnouts can put a strain on
the new working relationship if not structured properly.
is an earnout? An earnout is a mechanism in which part of the purchase
price is contingent upon future performance. A typical earnout might
include payments to the seller every year for three years based on a
percentage of operating income that exceeds a certain threshold.
are earnouts used? Earnouts can bridge the gap when the buyer and
seller cannot agree on price and terms. The parties often have
different views about the degree of certainty of achieving future
objectives. Earnouts allow the seller to receive full compensation for
creating value, especially if much of the value has yet to be realized
and the buyer is unwilling to pay the total amount up-front.
the technology arena, many companies are acquired after they have
created valuable technology, but before they have had time to prove
that value in the marketplace, through revenues and profits. New
technologies are often developed by small, innovative companies and
sold to larger firms with the marketing resources and distribution
channels to capitalize on the opportunity.
acquisitions are often difficult to value because the profits and
revenues may be minimal or nonexistent. An earnout may be a way to
obtain a higher purchase price by proving the market value of their
technology to the buyer. One drawback with earnouts in the technology
sector is that they often tightly integrate technology acquisitions
with the buying company, making earnout measurements more unwieldy.
discussions can be fruitful even if an earnout is not included in the
final transaction structure. Exploring a possible earnout will flesh
out many issues in more depth than might otherwise be the case.
can provoke a number of questions, such as "What is the marketing
budget for this division? Who will control spending decisions? What are
the gross margin objectives? Are we sacrificing long term objectives
for shorter term profits?" This discussion may bring the parties closer
together on price.
When Earnouts are
should an earnout be used? Earnouts can be a good structure when the
buyer and seller cannot agree on the price to pay for the upside
potential of the acquired company. If a large portion of the value
depends on future events, such as the completion of a product line, an
earnout may be appropriate. Earnouts are most successful when the
operating entity continues to be independent after the acquisition.
should not be used when the operations are tightly integrated. It is
too difficult to determine if objectives were achieved because of the
entrepreneur's efforts or because of the buyer's salespeople,
distribution channels or other assets. Earnouts should not be used when
the new owner wants to operate the acquired business his way.
can be based on revenues, operating income, development goals, or any
number of factors. A good negotiator will uncover as much as possible
about each side's risk preference, needs and motivations in order to
structure an earnout that meets each party's objectives.
performance goals should be obtainable, not pie in the sky. Gross
profit is probably a better measure than net profit since it is less
subject to non-operating influences. Graduated payments are better than
an all-or-nothing scheme. The time frame for the earnout should be one
to three years -- any longer than that and the mechanism becomes too
Traps to Avoid
problems can plague an earnout. How is operating income or profit
calculated? How are net sales defined? Should depreciation or
non-recurring events affect the measurement? What about technology that
is only a small part of a product?
Most problems in earnouts
stem from control and budget issues. The biggest trap to avoid is
agreeing to an earnout without having sufficient control over the
division and its marketing budgets. The entrepreneur must make sure
that he will have full access to the resources needed to run the
division, in both dollars and people. The marketing budget or
development budget should be definitive.
Use easily measurable milestones. Revenues are easier to measure than
profits. The payout should be directly associated with the performance
of the acquired. Make sure the calculations for the earnout formula are
straightforward. Complex calculations can muddy the water, create bad
blood and take a manager's focus away from running the business. Keep
2. Management should have the operating freedom and
the resources necessary to achieve their performance objectives.
Management must have control over the division's operations.
3. Commit to a budget, especially a marketing budget. Be sure the
needed resources are under the control of the manager.
Put a time cap on the earnout. At some point operations will become
integrated and it will make sense to eliminate the trouble of earnout
5. Do not put a dollar limit on the earnout.
This makes eminent philosophical sense, but in practice it can be
difficult to overcome the emotional element in buyers who think "How
could we pay that much for this company?" It is somewhat analogous to
the salesman earning more than the president -- it makes sense but is a
little hard to swallow.
6. And, lastly, try to structure the
transaction without an earnout. Life will be much simpler down the
road. There is enough to worry about in most high tech growth companies
without compounding the problem with a complicated earnout structure.
buyer can always add normal incentives, such as stock options and
bonuses, as part of the employment agreement. One transaction we
structured included an up-front payment in stock combined with an
employment agreement that included a sizable bonus. The bonus depended
one third on certain product development goals, one third on the
performance of the division, and one third on the financial performance
of the parent.