An “earn-out” is a tool acquirers use to reduce the risk of buying your business. An earn-out is usually used when there is a big gap between what you want to sell your business for and what the buyer is prepared to pay. An earn-out offers a way for an acquirer to reduce their risk in buying your business while—at least in theory—it gives you an opportunity to reap some of the benefits resulting from the merger of two companies.
Earn-outs come in all different forms but the basic formula involves being paid a cash amount for your business up front and then getting paid specified amounts in the future if you reach certain goals agreed with the acquirer.
Your earn-out goals could be tied to the profit your company makes as a division of your new parent, sales you make, the retention of a specific customer or just about any other factor your acquirer thinks is important.
It all sounds reasonable when presented to you by some corporate development wonk in a $3,000 suit, but in many cases, an earn-out can go horribly wrong.
Lessons From More Than 100 Exits
On Built to Sell Radio, I’ve now interviewed close to 100 owners who recently sold their companies and, along with a couple of success stories, I have heard a lot of earn-out horror stories both on and off the air. Part of the problem is that once you sell your business, you go from controlling every aspect of your company to simply running a division of someone else’s company as an employee with a goal.
As an employee, you can’t unilaterally make decisions. You will instead have to start asking for permission, begging for budget dollars, justifying your hiring decisions and generally sucking up. In essence, you lose control over the resources you need to hit the goals you’ve agreed to. Here’s a list of some of the most common reasons earn-outs go bad:
Head Office Expenses
When you become a division of another company, your financials are typically reported by the new company’s CFO who may apply new expenses to your Profit and Loss (P&L) statement because he/she charges certain head office expenses to all their divisions. If your earn-out is tied to profits, you can be in for an unpleasant surprise.
No Investment
Your earn-out goals will likely require investment to help you reach them and if your acquirer fails to fund your division, it will become hard to hit your goals. This is particularly true if your earn-out targets are tied to sales increases.
Acquisition
If the company that acquires you turns around and gets acquired itself, expect your earn-out to be a challenge unless you had a bullet proof legal provision to protect against this scenario. You’re now one big degree of separation away from the decision makers on whether you get your earn-out cash and when your direct contacts at the acquirer leave or change jobs, it can be hard to gather the internal support to get the buyer to honor the terms of your agreement (this is the situation Eric Sit found himself in when he sold CyberWAVE).
Falling Off The Ramp
Most earn-out goals build on each other. You get the budget to achieve Goal 2 by hitting Goal 1. Miss one goal early in your earn-out contract and it creates a domino effect that make it impossible to get the resources to hit your longer terms goals. This happened to Rod Drury, the founder of Xero, who got the money to start his latest software company through the sale of AfterMail to Quest. Quest acquired AfterMail for $15 million in cash with a potential for up to $45 million in consideration if he hit his earn-out. It took Drury a few months to figure out the Quest corporate and sales culture and by the time he knew how to navigate his new job, he had missed his first targets, making it close to impossible to hit the balance of his earn-out goals. He ended up walking away with nothing to show for his $30 million potential earn-out.
The best way to avoid an earn-out is to make sure your business is an attractive asset that garners multiple offers, which will allow you to dictate your terms. My day job is running The Value Builder System where we evaluate companies from the perspective of a buyer and score each business on a scale of 0 to 100 based on eight unique factors that acquirers look at. The higher your score on our questionnaire, the less likely you are to receive an earn-out.
Even if you have the most desirable business, you still may receive an offer that includes an earn-out. So, what do you do? First, you should hire a solid M&A lawyer who has seen earn-outs blow up and can paper your deal to protect you as much as possible.
Even with a bulletproof agreement, the buyer can choose to ignore your contract and bet you won’t have the stomach for a long court battle to try and enforce your rights under the agreement.
This leads me to my final piece of advice: get as much of your money as possible up front. This achieves two things. First, it guarantees you a minimum haul from the sale of your business if you never see a dime of your earn-out proceeds. Secondly—perhaps even more importantly—if you get a large cash payment up front, the buyer will know you have plenty of money in the bank to finance a court battle to enforce your earn-out agreement. A well-financed opponent has a funny way of keeping a would-be crook honest.
