When there is a disagreement between an acquirer and a seller about the value of a company, yet determination to get the deal done, an earnout is often put in place. The earnout essentially defers some of the purchase price to a future time (typically one year), and it is paid after the company achieves certain performance goals. Let’s say that 20% of the purchase price is deferred for 12 months. The buyer and the seller then set the performance targets that must be hit before the payout is triggered. The goals can be tied to overall sales, retention of customers, as well as other factors, but they are much more likely to be tied to EBITDA. That is the true indication of the profitability of the company, the very origin of the phrase the bottom line. Earnouts are typically put in place for a period of time when the seller(s) remain in a place in a management role under new ownership, when they are highly motivated to achieve the earnout performance goals, because a big check awaits.
At the time the deal closes, there is often a great deal of optimism about the future prospects of the company. The new owners may be bringing expertise, new management, resources, buying power, and alliances to bear to help the acquired company along. But here’s a common point of friction in earned-out deals: The sellers, no longer with the powers of outright ownership, may see that the very resources required to achieve the earnout are restricted by the new owners.
For instance, the new owners may restrict the marketing budget, cut down on sales staff, reduce the percentage of revenue dedicated to trade shows and events, or start charging additional expenses against the seller’s budget. When that happens, it is not uncommon for the sellers to look at the budget and ask each other, “How are we supposed to achieve the target EBITDA when we are down two sales reps, skipping two home shows, and our ad budget is cut 30%?” What’s more, it’s only human nature that the sellers might suspect that the constriction of resources might not just be a run-of-the-mill budgeting issue, but a deliberate attempt to deny them what’s required to trigger the earnout.
The sellers may go to the new owner and appeal, saying that the marketing budget used to be 6% of gross revenues, and now it’s only 4% of gross revenues. The new owners might point out that all their other operations run just fine on 4% of gross revenue models, and that is just standard policy, with no ulterior motive whatsoever. “But what about the fact that you let two sales reps go?” the sellers may ask. The buyers respond: “Their sales territories overlapped with two of our top guys, and we didn’t want the overlap.” The sellers are left stymied and frustrated, as they see the chances dwindle for that last big check.
There are two tactics for avoiding this problem. One is to negotiate before the close, as a covenant of the purchase agreement, that the earnout is not “all or none,” which is what the buyers will push for. In other words, the buyer will say, “If you hit that $2 million EBITDA, you get the earnout, but anything under $2 million means no earn out will be paid.” The sellers should counter that if 90% of the $2 million is obtained, 90% of the earnout shall be paid; 80% achieved, 80% paid, etc. (There can be lots of creativity and “horse trading” around these payment structures, e.g. 90% of the $2 million achieved, 75% of the earnout paid; 80% of $2 million achieved, 50% of the earnout paid, etc.). The second tactic is to set the coming year’s marketing budgets and staffing levels before the deal closes, so you know you’ll have the resources required to achieve the earnout goals. The marketing budget may not be set as a dollar amount, but as a percentage of revenues; the events listed out that you know you will attend; the sales rep’s territories spelled out. By knowing in advance what resources you have to work with, you can focus on performance, and not on the fact that you were deprived of resources to achieve your earnout targets.
John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at email@example.com.