Earn-out not burnout: the secret to post-deal success

When the late US entre­pre­neur Tony Hsieh sold LinkEx­change, the adver­tis­ing ven­ture he’d co-found­ed in 1996, to Microsoft less than three years lat­er, he received $40m (£24m) imme­di­ate­ly. He was due to earn a fur­ther $8m from the deal if he stayed with the busi­ness for 12 more months. 

In his 2010 auto­bi­og­ra­phy, Deliv­er­ing Hap­pi­ness, Hsieh used the pun “vest in peace” to describe the bore­dom that led him to walk away from LinkEx­change before the year was up. That phrase has since become a Sil­i­con Val­ley cliché. It refers to what hap­pens when an entre­pre­neur sells their busi­ness and receives a tranche of share options that mature (vest) in a year or two, under an arrange­ment known as an earn-out. Until that final pay-off, they loaf around, offer­ing lit­tle val­ue to the busi­ness they worked hard to build. The impli­ca­tion is that earn-outs are inef­fec­tive incen­tives. 

“I wasn’t going to sit around let­ting my life and the world pass me by,” Hsieh wrote. “Peo­ple thought I was crazy for giv­ing up all that mon­ey. And, yes, mak­ing that deci­sion was scary, but in a good way.”

Earn-outs are sup­posed to ren­der acqui­si­tions more attrac­tive to both par­ties. Sell­ers can close deals that may not oth­er­wise hap­pen and acquir­ers can reduce their ini­tial costs while incen­tivis­ing the founders to ensure that the busi­ness con­tin­ues to pros­per after the sale. Yet many sell­ers feel that such arrange­ments, espe­cial­ly those that impose unre­al­is­tic per­for­mance tar­gets as a con­di­tion of fur­ther rewards, are biased against them. 

Earn-outs rarely work out well for sell­ers. Many cor­po­rate financiers will advise them to obtain some more uncon­di­tion­al mon­ey instead

William Pin­nock, head of the cor­po­rate and com­mer­cial team at Glaisy­er Solic­i­tors, agrees that “earn-outs rarely work out well for sell­ers. Many cor­po­rate financiers recog­nise this and will advise their sell­ing clients to sac­ri­fice at least some of a poten­tial earn-out sum to obtain some more uncon­di­tion­al mon­ey instead.”

So how can earn-outs be struc­tured to be more equi­table and effec­tive? For one thing, both par­ties need to be sure about what they’re agree­ing to at the out­set. So says Stephen Page, founder and CEO of SFC Cap­i­tal (for­mer­ly known as the Start­up Fund­ing Club), who observes that many such agree­ments are not spe­cif­ic enough. 

“Pit­falls are all in the lan­guage of the deal,” he notes. “There can be grey areas with­in the terms.” (See pan­el, oppo­site page.)

Dan Cop­pel, a Lon­don-based cor­po­rate part­ner at glob­al law firm Mor­ri­son & Foer­ster, agrees. He argues that earn-outs should offer sell­ers greater pro­tec­tion against risks that will be beyond their con­trol.

“What if the buy­er doesn’t allo­cate the resources nec­es­sary for the sell­er to hit their tar­gets? Or what if it restruc­tures the busi­ness, mak­ing it prob­lem­at­ic to track per­for­mance? Fail­ure to account for such fac­tors in a deal means that sell­ers can be short-changed through no fault of their own,” he says.

Karen Thomas-Bland, the founder and direc­tor of Intel­li­gent Trans­for­ma­tion Part­ners, has worked as an advis­er on about 50 M&As. She believes that sell­ers need to be grant­ed a mean­ing­ful say in how the busi­ness is run even after they’ve part­ed with most of their equi­ty. 

“They need to keep oper­a­tional con­trol dur­ing the earn-out peri­od, while per­for­mance met­rics need to be unam­bigu­ous and eas­i­er to track than, for exam­ple, net income or Ebit­da,” Thomas-Bland argues. 

She also rec­om­mends that pay-out terms be made more flex­i­ble, enabling sell­ers to be reward­ed on a slid­ing scale accord­ing to their achieve­ments. This is fair­er than a so-called cliff-edge arrange­ment, under which they would receive either the full amount or noth­ing, depend­ing on whether they hit all their tar­gets or not.

Struc­tur­ing earn-outs as a clear win-win sit­u­a­tion is the method favoured by Peter Blanc, one of the UK’s most pro­lif­ic acquir­ers. So far this year he’s over­seen 14 M&As for char­tered insur­ance bro­ker Aston Lark, where he’s group CEO. 

“We’ll com­plete about 30 deals this year,” pre­dicts Blanc, who explains that the earn-out deals offered by his firm “avoid trig­ger events, because these can cre­ate unwel­come behav­iour. For instance, we wouldn’t want to cre­ate a sit­u­a­tion where a ven­dor knows that they would receive a large pay-out if they were to sell anoth­er £100,000-worth of insur­ance. That would lead to bad client out­comes.” 

He con­tin­ues: “Our think­ing is sim­ple: we offer them a mul­ti­ple of what­ev­er pro­ceeds are earned over the two or three years they’re tied in. That’s a sen­si­ble reward – and it means that we don’t have that hor­ri­ble cliff edge where they would risk los­ing a big sum.”

This approach means that sell­ers receive a decent price for their com­pa­ny and are also moti­vat­ed to make the busi­ness more prof­itable, know­ing that they’ll ben­e­fit fair­ly from such an out­come. 

“We nev­er put in any claw­back pro­vi­sions. It’s all car­rot; no stick,” says Blanc, who adds that hav­ing an hon­est con­ver­sa­tion with the sell­er ensures that both par­ties are clear about what they want from the deal. “If a ven­dor wants to go to Mona­co and be a play­boy, say, that’s fine – as long as he leaves a man­age­ment team behind to run the busi­ness.”

Such a can­did approach has the added ben­e­fit of reduc­ing the like­li­hood of a cul­ture clash. This is “prob­a­bly one of the biggest risks in earn-outs”, says Sangee­ta Mis­try, a spe­cial­ist in reward at M&A inte­gra­tion con­sul­tan­cy Glob­al PMI Part­ners. 

“Typ­i­cal­ly, founders who may not be suit­ed to cor­po­rate life will leave the acquired com­pa­ny as soon as their earn-out peri­od ends,” she explains. This can result in a mass exo­dus if the acquir­er is retain­ing sev­er­al sell­ers who are due for pay-outs at the same time – a sig­nif­i­cant prob­lem if it hasn’t done the req­ui­site suc­ces­sion plan­ning. 

“We’ve also seen sit­u­a­tions where founders are pro­tec­tive of their staff while still in posi­tion. This makes it hard­er for the buy­er to plan any restruc­tur­ing,” Mis­try adds.

Ulti­mate­ly, earn-outs need to work for both par­ties in prac­tice as well as in the­o­ry. Oth­er­wise, like Tony Hsieh, the per­son who built the busi­ness will walk away – even if mil­lions are on the table – ren­der­ing the whole exer­cise point­less.

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Common earn-out mistakes

Here are some of the most inad­vis­able prac­tices that buy­ers and sell­ers often engage in. 

Involving the lawyers on day one

An acqui­si­tion is a meet­ing of minds, espe­cial­ly when all the founders and their entire man­age­ment team are being retained. A deal requires good­will and under­stand­ing between the par­ties. The moment that legal doc­u­ments are draft­ed, the mood changes, so don’t call on the lawyers until you’ve built a strong enough rap­port.

Relying on a template

Every deal is dif­fer­ent. An earn-out will require agree­ment on the right mea­sures. Turnover and Ebit­da are com­mon start­ing points, but oth­er met­rics can include client reten­tion, rev­enue per cus­tomer and cost sav­ings achieved through ‘syn­er­gies’. Non-finan­cial met­rics – reg­u­la­to­ry approvals for new med­i­cines in the phar­ma sec­tor, for instance – can prove use­ful too. 

Going to the cliff edge

This is a deal that’s struc­tured so that the sell­er receives all or noth­ing, depend­ing on whether they hit an absolute tar­get or not. Such deals encour­age ‘mali­cious com­pli­ance’: the pur­suit of tar­gets despite the harm this may cause the busi­ness – for instance, offer­ing loss-mak­ing dis­counts to attract a set num­ber of new cus­tomers. 

Failing to provide adequately for force majeure

An earn-out can be affect­ed by polit­i­cal, social and even geo­log­i­cal events beyond the con­trol of any par­ty that will nul­li­fy its reward struc­ture. The arrange­ment should account for the unex­pect­ed in advance. Defin­ing force majeure is noto­ri­ous­ly tricky – this is one area where the lawyers real­ly earn their fees.

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