How To Survive An Earnout

Tuesday, September 13, 2005

Anne Field, BusinessWeek SmallBiz - Summer 2005, http://

Carefully Craft M&A Earnouts Or Risk Losing Half The Payout

BusinessWeek SmallBiz - Summer 2005, Pgs. 71-74

Leave early, and lose half the payout.
Half of the small-business acquisitions these days include an earnout provision. Part of the sale price is paid out at the closing, Anne Field explains, and the rest is paid only if financial targets are met in the year or two after the acquisition. Typically 15% to 30% of the total sale price paid is contingent on earnout requirements, but that can rise to 50% in some deals. Often, to receive the entire payment, the entrepreneur must remain with the new company throughout the entire earnout period. To maximize the final earnout, structure safeguards into the deal to offset activities that would reduce the final purchase price.

While the inclusion of an earnout clause may be necessary to cement a deal (particularly in growth industries with unproven products), sellers need to craft an agreement that gives them an opportunity to actually collect, since crafty buyers could undermine the performance requirements just to avoid earnout payments.

Retain control over earnout criteria.
If the seller must remain with the new company to collect the earnout, then the employment contract should provide exit conditions that still permit payment of the earnout. As examples, the author mentions termination of the seller's employment by the acquiror or sale of the small business to a third party. The measurement of profits can prove particularly tricky and may need special definition for the purposes of an earnout, because the acquiror can simply spend what would have been profit, expanding the business but undermining the earnout. Deliberately increasing overhead in other ways can also deprive the seller of earnout payments. Revenues, number of customers, and customer retention might be safer ways to structure an earnout, although even here the seller needs to define what actions by the acquiror will modify the figures.

For example, if the buyer sells a unit of the company or stops production of certain products, these acts should change the conditions of the earnout. In addition, make sure that an earnout is based on a sliding scale rather than all-or-nothing calculations.
Once an owner, now merely an employee. The seller ought to anticipate strategies to undermine the earnout criteria and add written safeguards into the deal before it is consummated. Even then, the author warns, the odds are good that not all of the earnout will actually be paid at the end of the stated period. Entrepreneurs typically find it irksome to work for someone else, particularly a successor who may have different ideas about running the company, so structure escape clauses and alternatives into the earnout agreement.
Psychologically the seller needs to cut the cord to the company and redefine what success means during the transitional phase of the deal. The seller should anticipate this shift in focus before agreeing to stay at the new company, carefully considering and defining the entrepreneur emeritus role.

Abstracted from BusinessWeek SmallBiz,
published by McGraw-Hill,
1221 Avenue of the Americas, New York, NY 10020.

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