Following up on Lesson #145, Issues to Consider Before Selling to Big Companies, I wanted to drill down deeper on earnouts and potential pitfalls to avoid, as earnouts rarely payout as expected.
First of all, what is an earnout? An earnout is typically a performance-based payment that has been agreed to be paid to selling shareholders, above and beyond any payments received upfront at closing the deal. For example, let’s say a buyer is willing to pay you $1MM upfront at closing and up to $4MM additional proceeds if your EBITDA exceeds a certain level within one year of closing. That $4MM part of the deal is the earnout portion, which is tied to future performance of the company.
Earnouts typically never pay out the way a selling company is hoping they will. This emphasizes the importance of making sure you are 100% content with the upfront proceeds only, in the event the earnout payout ends up being zero. There are numerous reasons why earnouts rarely pay out as planned, including: (i) the way they were actually written, which can end up benefitting the buyer; (ii) the buyer is not naturally motivated to have their behavior drive additional proceeds to the seller; (iii) the pace that businesses post a sale is materially slower than life before the sale; and (iv) unexpected things can happen that may or may not be in your control. I will address each of the points below.
In terms of how an earnout is written, the devil is in the details. The first issue is whether future revenues (which is in the seller’s benefit) or future EBITDA (which is in the buyer’s benefit) drive it. Revenue is 100% clear and clean, but buyers do not want sellers to load up marketing losses to try to juice up revenues to get a higher payout. On the flipside, sellers should be wary of an EBITDA-based earnout because after they sell the company, there could be a lot of corporate expenses, which may be pushed down to a divisional level which hurts EBITDA and the earnout.
Additionally, other things can manipulate earnout payment calculations, like making adjustments for any the company’s net working capital changes. Balance sheet movements are a lot harder to control than income statement movements. For example, you can’t control how fast your vendors pay your accounts receivable owed to you, meaning any inflation in your collection time could decrease your earnout payment. Capital expenditure-based adjustments experience the same thing, where any monies you spend on needed asset purchases to drive your growth could also end up hurting your expected payout.
Let’s face facts, a buyer is typically more than happy to wait a year before investing a lot of their promotion support in your business (which you are hoping for to drive the earnout). From a buyer’s perspective, why pay $5MM for a business, when you can pay $1MM with no additional earnout payments made? Unless you detail otherwise in your agreement, don’t expect the buyer to be doing a lot of sales or marketing favors for you during the earnout period.
Worse, though, is if you protect yourself from the buyer loading up a lot of expenses during the earnout period because that can hurt your payout. For example, sales and marketing expenses today will help long term growth of the buyer, but they will come at a loss during the earnout period. That is, until the future revenues are driving for the buyer well after the earnout period has ended, which is great for them but horrible for you.
As mentioned in Lesson #145, when selling to big companies, don’t expect the way things operated for your company to be the same after the sale. Typically, the pace of business will get a lot slower, based on both new corporate tasks required and the slower decision making process of bigger companies. It may feel like you are no longer swimming in a pool of water any longer, but in a pool of molasses. Any slowdown in pace could impact your ability to maximize the earnout payout.
There are many unexpected things that could happen during the earnout period that can hurt the payout. Perhaps there is a big hit to the economy, like there was around September 11th. Or a hurricane wipes out your home office in New Orleans. Or your salesperson is “cooking his books” to drive more commissions, only to find out the contracts were never real too late in the earnout period to actually make up for the unexpected shortfall. This last point actually happened to one of my businesses during its earnout period, costing the shareholders around $3MM of additional proceeds.
As you can see, I am pretty bearish about earnouts. In order to get your shareholders a reasonable way to achieve their ROI objectives, sometimes you have no choice. When you use an earnout structure, make sure: (i) it is “iron clad” in its drafting, leaving no confusion and no opportunities for the buyer to manipulate the calculation; (ii) negotiate for the buyer to bring full promotional support from day one at no impact to the payout calculation; (iii) make sure you are realistic on what life will be like post-sale to make you are still happy with the deal with slower growth assumptions; and (iv) make sure the business is largely run as-is until the earnout period has ended to prevent any unexpected buyer expenses, decisions or process that could negatively impact the earnout.
This article was originally published on RedRocket VC, a consulting and financial advisory firm with expertise in serving the start-up, digital and venture community.
Image credit: CC by Kenny Louie