Top Four Ways To Avoid Being Burned By An Earn-Out

This following column was provided by Mark Davis. Mark is the author of Get Venture, a column designed to help entrepreneurs raise venture capital. He currently works at DFJ Gotham Ventures, a leading early-stage IT venture capital fund based in NYC.

When acquirers and the shareholders of a company come to an impasse on valuation based upon assumptions about future performance, the pricing gap is sometimes bridged through an earn-out. In an earn-out, the buyer agrees to pay the current shareholders additional compensation as pre-determined future operating metrics are achieved.

For example, if shareholders expect sales to increase next year and the acquirer doesn’t, the acquirer might agree to pay more for the company in the future if sales do in fact increase. Doing so enables the acquirer to protect itself from paying too much for the target in the event that sales don’t increase – the seller takes on the performance risk.

While structures vary greatly, in the plain vanilla version the target is purchased for a base price with the possibility of an additional earn-out. Earn-outs need to be well defined to ensure that both parties know when the payouts are triggered.

While in theory earn-outs are quite simple, these structures can make it difficult for unprepared entrepreneurs to get their fair payouts. One of my mentors, Jed Katz, has lots of his experience as both an operator and investor. During his time as an entrepreneur, he learned a few tactics that can help entrepreneurs increase their chances of maximizing their payouts. Here they are – the top four ways to avoid being burned by an earn-out:

#1 Base The Earn-Out On Simple Metrics

Earn-outs are most effective when the size of the payout is determined based upon one or two simple variables.

For example, higher revenue might lead to a higher payout to the shareholders of the acquired company.

In contrast, imagine an earn-out based upon price changes, customer acquisition cost and customer retention. To complicate matters, these variables might be woven together in an arbitrary equation that provides each metric with a weighting. In pursuit of maximizing the payout, management might focus on trying to optimize too many variables in the business, potentially resulting both in management not focusing on what matters most to the buyer and making it difficult for management to maximize their payouts.

Simplicity provides incentive alignment, clear objectives and less room for argument when it comes time to sign the check.

#2 Base The Earn-Out On Metrics You Can Control

The metric used to determine the size of the earn-out can vary – it’s negotiable. It could be a financial metrics (e.g., revenue, gross profit, EBITDA, etc.) or an operating metric (e.g., page-views, customers, etc.).

Entrepreneurs need to be sure that the selected metric is one that they can directly influence after the acquisition. For companies that are acquired for their cash flows (probably EBIT in this case) it’s important to base the size of the earn-out on a top line metric, such as revenue. There is good reason for this – the expenses allocated to the target might be very different once the target is integrated into the acquirer. Transfer pricing, overhead expense allocation and new accounting methodologies may drastically alter bottom line figures. As a division of the acquirer, the company’s EBITDA margin might be half of what it was before the acquisition – making it difficult for a management team to meet EBITDA growth targets.

This same logic applies to companies that are acquired before they are generating revenue. If a company is acquired because it generates lots of page-views, but no revenue, management should be wary to base an earn-out on revenue. If these entrepreneurs find themselves stuck using a poor monetization solution (that is mandated by the buyer), the revenue targets may not be in their control. In a case like this, management might only be in direct control over the number of page-views and therefore that’s the target metric that payouts should be based upon.

#3 Ensure Access To Sufficient Resources

Imagine it’s the day after you inked the sale of your company. Much of your pay-out is based upon meeting revenue targets in the coming quarters, but you’re confident that you’ll meet the revenue targets – managing this business is as easy as turning a crank at this point. You’re on cloud nine. That is, until you check your voicemail.

The second message is from the CEO of the buying company, your new boss. He notifies you that your marketing budget has just been cut in half as part of a cost cutting exercise. You know that it is now impossible to meet the revenue growth targets outlined in the earn-out – you’re not going to be able to maximize your pay-out. You just sold your company at a discount.

Scary scenario? You bet. Here’s another.

You are two months into the agreed upon one year employment at the buyer’s company. You have been instrumental in ensuring that your company, now a division of the mother-ship, is hitting its numbers. With close monitoring, you’re confident you’ll get the rest of your payout.

After getting settled into your office for the day you head over to the CEO’s surprise strategy meeting, where he introduces a new product line that he feels you would be perfect to run (since you’re the only person in the company that has built anything in that sector). Aware of your commitment to your division he asks you to split your time – allocating 50% of your attention to the new product line. You leave the meeting trying to find a way to reposition yourself, as you’re worried that your division won’t perform enough to meet the earn-out benchmarks without your full attention.

While it’s impossible to layout all of the details around the resources (staff, capital and your own time) you’ll need when you enter into an earn-out, you should try to obtain agreement from the buyer about your resource availability and you should have your lawyers bake in some language that can protect you.

You should also try to create a formal mechanism for increasing your resources as needed. If market dynamics change, market rates for key resources change or unique opportunities present themselves, you need to be able to take advantage of those changes. Incentives should be aligned; it’s bad for everyone if the company stifles your business’ growth just to minimize your earn-out. Having a pre-defined process for making these adjustments can help along the way. One approach is to have a formal quarterly review of your resource allocation that includes all of the appropriate people.

#4 Keep The Earn-Out Period Short

It’s important for entrepreneurs to negotiate hard to limit the length of time under which the earn-out metrics are evaluated. There are two key reasons for this: external and internal changes.

First, exogenous factors can limit an entrepreneur’s ability to maximize their payout. If the economy falls into a recession during the earn-out, revenue targets might not be as viable. The longer the earn-out period, the more risk the entrepreneur is taking.

Second, as more time passes the odds of the buyer’s strategy changing increase. While leveraging your company may have been a strategic imperative when it was acquired, market dynamics may dictate a different strategy post-acquisition. Or, perhaps, a new management team was brought into run your acquirer. Either of these factors (and many others) could lead to a change in priorities which could leave your business last in line to receive capital, support or other mission-critical resources.

In sum, it is advantageous for entrepreneurs to minimize the length of the earn-out (so long as they have sufficient time to meet their earn-out benchmarks).