Earnouts: More important than ever
Published: Dec 9, 2010
Corum Group Ltd.
Click image to enlarge
If you're selling your company, an earnout could be your best friend or your worst enemy. Here's why.
Believe it or not, the structure of your transaction is even more important than the total price you receive. What good is a premium valuation if you never actually get the money? However, buyers are wary of giving sellers all the cash and then, after the deal closes, finding that the anticipated ROI just isn't there. A well structured transaction, even with an earnout, helps ensure that the “transaction consideration" becomes real money for the seller.
By being flexible on transaction structure, the seller can maximize the total deal value. If a buyer won't pay the price a seller wants all in cash and all at closing, then an earnout might be the best way to bridge the valuation gap and get the deal done.
The key to a successful earnout depends on having a firm grasp on the dynamics of the seller's business, understanding the nuances and implications of complex legal terminology, and creating a framework where all parties benefit in the circumstances that give rise to the future earnout payments. It takes a great deal of experience to craft earnout terms that can be successful from both the buyer's and the seller's perspectives.
Whether the seller ever realizes any payment under an earnout depends on how the earnout is negotiated. This makes the critical difference between an earnout that helps a seller get the price they want, or an earnout that evaporates and leaves the seller angry, frustrated and feeling cheated. Buyers have used earnouts to avoid making future payments by negotiating terms that are unrealistic or filled with off-ramps that leave the earnout in doubt. Sellers should get experienced help to navigate this difficult process.
Here are some tips for seller's negotiating an earnout.
1. The amount paid at closing has to be “enough" to satisfy your minimum amount, even if you don't get a dollar of the additional earnout. If the amount paid at closing falls short of that minimum requirement, however you arrive at that baseline figure, then continue working the deal to reach that point.
2. Make sure the earnout is achievable and within your ability to influence after closing. Payments under an earnout structure are usually tied to performance targets, so the definition of those targets is critical. It's not effective to tie your earnout consideration to a target that is outside your control. It's also not a good idea to tie the earnout to a metric where the seller's and buyer's interests are not well aligned. For example, a buyer might circumvent a profit-based earnout by allocating corporate G&A costs into the seller's P&L.
3. Avoid “all or nothing" binary provisions. Rather than having terms that give you all of the earnout or none of it, negotiate for payments that scale from zero to the full earnout based on an analog scale for the performance metric.
4. Negotiate “make up" terms that allow you to recoup earnout payments that you might miss by overperforming in the future. This enables the seller to use performance “peaks" to fill in “valleys" and compensate for unforeseen shortfalls. These terms can be good for the buyer because it keeps incentives in front the seller for the entire term of the earnout.
5. Determine what commitments you need the buyer to make in order for the earnout to be achievable; the resources you need to achieve the goals must be available to you. Negotiate for those to be included within the definition of the earnout. For example, do you need a certain marketing and sales budget to hit future revenue objectives?
6. Identify reasonable decisions a buyer might make in the future that could jeopardize your ability to achieve the earnout. A buyer might decide to re-focus on its core business and then sell the product line on which your earnout depends. Negotiate terms that protect you from such eventualities.
It's true a badly structured earnout is useless or worse. It might cost you your company.
However, a well structured earnout based on achievable objectives that take advantage of the aligned interests of buyer and seller can be an effective way for a seller to realize their dreams.
Mark S. Reed
Executive Vice President
Mark joined Corum in 1997. During 1999 he took a sabbatical to participate in the launch of an Internet startup company, WorldStream Communications, as Vice President of Corporate Development. At WorldStream, Mark developed the core business plan, was a driving force behind the emphasis on B2B services, and launched their strategic alliance program.
Prior to Corum, Mark served as Executive Vice President of a boutique investment bank where he concentrated on providing private equity financing and arranging cross-border strategic alliances for high technology companies. Mark also served as Chief Operating Officer of a consulting company, advising multinational organizations such as Shell International Petroleum and the International Finance Corporation (World Bank Group) on new business development and foreign direct investment into Asia.
Before moving into the finance sector, Mark was a software developer and project manager building application software on DEC and HP mini-computers. Mark studied mathematics and computer science at Seattle Pacific University and the University of Washington. He has a B.S. in Mathematics.
For more information or questions regarding the merging of IT companies, feel free to contact me at mreed@corumgroup.com