25 May 2007

Earnouts are for Sissies

The ultimate founder transition - when the time comes for a founder to sell his or her "baby" - the highest hurdle encountered is often the PRICE. Buyers and sellers may find that there is a large gulf between the realistic value for the company and the price the seller is willing to take. Whether this is due to asymmetric information, scarcity, or the psychology of a founder expecting their kid (like in Lake Wobegon) always being better than average, it does create an obstacle to completing the transaction.

All too often, this gulf is bridged with a mechanism commonly called an earnout. An earnout is simply a way to pay less money today and (perhaps) more money in the future, based upon "proving" the value is actually higher than it appears today. How do you prove it? Typically, by increasing revenue, earnings, or the accomplishment of prescribed milestones.

So the seller agrees to take less cash today with the promise of a future upside (sounds very entrepreneurial) and the buyer agrees to pay what she believes to be the value today and something in the future if certain conditions are met. In theory, this appears to be a sound compromise. In practice, it often becomes a contentious and inexact computation.

So, if they appear so promising, why don't earnouts work?

Less than obvious to the innocent bystander is the fact that an earnout is used to paper over a disagreement. Like any good, long term relationship, a firm foundation of understanding, trust, and agreement is required to perpetuate the relationship. One founded on a disagreement is an indication of the quality of its construction.

Extenuating circumstances become the rule, not the exception. Once merged together, decision making on issues that may impact the trigger criteria may fall under the control of the buyer. While reputable buyers may not purposefully "game" the system to ensure that triggers are not met, they may in fact find that it is in the interests of the now "greater good" for the business to be run in a way that no longer hits those triggers. And guess who is making those calls now? Usually, it is not the seller - who has the vested interested in hitting those targets.

Who determines the payout? Sellers should understand that once a transaction is completed, the "golden rule" controls. (The "golden rule" is usually understood to be - he who holds the gold, makes the rules!) Buyers will make the determination as to when and if additional payouts occur. While agreements may be carefully crafted by expensive and sometimes even competent counsel, in practice it just may not be clear whether or not the trigger criteria has been met, several years into the future - especially if in between, the game has changed.

History has shown that earnouts don't always get paid out at the times or at the values that the seller had expected.

So should a Seller just say no? The realistic answer is no (I think that is a double negative!). Earnouts are ok to use as a seller if the expectation is clearly set that this portion of the potential purchase price is just gravy (or icing on the cake if you like that analogy better). Negotiating a purchase price that is "acceptable" even if the earnout is not paid, and accepting the earnout as a potential extra to the deal, will lead to a much sounder future relationship.

Of course if you are buyer - Earnouts are great!

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