Sep 30, 2018

How the promise of a windfall can make a seller cut corners

An earn-out is a tricky but powerful device to bridge a price gap between the buyer and the seller of a business. It is a form of deferred consideration that depends on the performance of the acquired company.

I have done more than a dozen earn-out deals — both as buyer and seller. It is a technique most often used in industries such as recruitment and advertising agencies, where founder-managers are critical to the company. An earn-out ties them in — at least for a period.

An earn-out is also common where the business in question is enjoying explosive growth, but the purchaser is not willing to pay for all of that exciting upside in advance. Typically, anywhere between 30% and 50% of the overall expected price will be linked to an earn-out in such deals.

Often the legal agreement for earn-outs is as long as the whole of the rest of the contract. They invariably make a deal more complicated and add to professional fees, but they may be the only way in some situations for a buyer to mitigate their risk, and for the seller to feel they will receive enough reward for their work.

One of the big difficulties with earn-outs is that they can distort the behaviour of the seller in terms of how they manage the business.

In such circumstances, sellers tend to be highly focused on hitting the targets needed to maximise their payout. This can lead to short-term decisions that boost profits but damage the business in the long run — but of course by then the seller will have left for good.

Protections for both sides in such an arrangement can be inserted in the sale and purchase contract, but ultimately it is almost impossible to legislate against every possible manipulation of trading or accounting.

I once bought a business that dealt in capital goods and consequently experienced very lumpy orders. The vendor quite deliberately persuaded his customers to place every conceivable order by his earn-out deadline, so he could show record profits and receive a multiple of that as part of the earn-out. Immediately following that period, revenues slumped, because orders had been pulled forward.

That experience taught me a lesson: always put strict caps on any earn-out element of a transaction — just in case a bumper, but unrepeatable, set of numbers is delivered.

Occasionally public companies pay for acquisitions using earn-outs that must be satisfied in shares. Trouble can arise, however, if the buyer’s share price slumps. There have been occasions where a seller receives so much stock in a parent company as part of an earn-out that they end up taking control. For that reason, contracts should have “cap and collar” limits on share numbers and share issue prices.

One big disadvantage of earn-outs for buyers is that, generally, they are unable to fully integrate the acquired company into their existing operation. Sellers usually insist on significant protections to ensure they are free to run their company and meet the earn-out obligations.

If the benefit of an acquisition involves significant restructuring or substantial synergies, through common procurement and so forth, then it can actually be better for the acquirer simply to pay the entire price initially and speed up the deal.

Many entrepreneurs regret using an earn-out mechanism when selling their company. They realise that without control of their business, they no longer enjoy work — even if they are notionally still the boss. Such independent spirits tend not to thrive inside large corporates.

Normally they either leave and forgo their earn-out, or they try to engineer a breach of the purchase contract by the buyer, so the earn-out payments are triggered in full.

Both the taxation and the accounting treatment of earn-outs can be complex. A poorly structured arrangement can lead to a vendor paying tax on an earn-out consideration they never actually receive. Meanwhile, buyers usually have to classify any contingent consideration as a liability in their balance sheets from the signing of the deal — even if it never gets paid.

Personally, I think earn-outs work only with the right sort of vendor and buyer. Many entrepreneurs are incapable of ever working inside a larger organisation, so should never do an earn-out — and certain buyers are too interfering and litigious to manage happily with the restrictions of an earn-out arrangement. In which case, the price must be all upfront — possibly with a share element so the vendor carries some risk, too.