EXIT STRATEGIES: Earnout

Owners of the selling firm often agree an earn-out is the best way of securing additional compensation for the business they are selling. This frequently occurs where the price the buyer is willing to offer is seen by the selling shareholders as inadequate compensation for the potential of the business.

Circumstances where this might occur are;

• Significant expenses have been incurred in recent research and development which has been written off but has not yet translated into revenue;
• The owners have taken either very low salaries or excessive salaries or benefits which are not able to be easily calculated;
• Large contracts have been secured, or are about to be secured, where the benefits have not flowed back into the accounts;
• The sector is experiencing significant growth and the firm is well poised to take advantage of that; and
• The potential acquirer is able to remove an impediment to growth which will return premium profits to the acquirer.

The selling shareholders argue for a higher valuation on the basis of potential.

The acquirer may be reluctant to agree the higher value arguing that the benefits may not be realised. The compromise is often negotiated as an earnout based on the future performance of the acquired firm or the combined entity.

Another reason for an earnout arrangement is a performance based purchase price where other activities or achievements other than revenue or profits may be the basis for such payments. This might include:

• Completion of development milestones
• Acceptance of products by named customers
• Completion of key contracts
• Signing of key agreements by customers, suppliers, partners or distributors
• Approval of products by licensing authorities
• Granting of rights under patents, trade marks, or licenses
• Achievement of various quality targets

Earnouts should be used where there is a reasonable level of uncertainty of some future event or future performance which can have a material impact on the value of the acquisition. There should also exist the possibility that none of the earnout will be earned if the anticipated events or targets are not met in a material manner.

Where events are more certain, such as the outcome of a litigation settlement, lease payout, warranty claim and so on, these are better handled through escrow arrangements and under warranties and representations. In these situations, the valuation is set on a positive note where all outstanding items are worth zero. A portion of the purchase price is then set aside, generally in escrow and claims are made against that portion as each item is finalized or settled. These items are generally discrete in nature, often able to be calculated in advance and not overly subject to effort by either party and will normally be limited in time.

The earnout approach is best used when the parties are not able to agree on a purchase price because future events, which could materially affect the value acquired, cannot be determined with any certainty. Alternatively, the buyer is willing to pay more but only if the seller can achieve certain predetermined performance or event objectives.

As a general rule, a good earnout formula is one where the buyer is very willing to pay the earnout if objectives are achieved and the seller has a reasonable degree of influence over the events which contribute to that level of achievement. A good earnout formula is also easily defined, measured and objective and not capable of manipulation by either party at the expense of the other.

Earnouts are however not as common as may be expected.

Example:

In an article in CFO magazine titled ‘Caution: Earnouts Ahead’, the author Roy Harris notes that contingency terms were found in 4 percent of all announced U.S. M&A deals, with over 10 percent of all deals valued at or below $250 million, encompassing such terms. More than two hundred acquisitions in the U.S. have contained earnout agreements in each of the five years to 2000, with a total value of such transactions peaking at $27.9 billion in the year 2000.

Source: Accessed 9th May 2004

Term of the earnout

There is considerable disagreement among practitioners about the most workable term of an earnout. On the one hand, shorter terms have higher degrees of likely achievement while longer terms allow for too many influencing events to occur. Also longer earnouts reflect lower present day values due to the discounted cash flow impact of distant payments. Thus the further out the potential payout, the less value it has for the sellers and the more likely it is to be disputed or not achieved.

Example:

Baltimore-based Sylvan Learning Systems Inc. certainly found it so. The company, a prolific acquirer of educational companies in recent years, started out by setting up one-year earnouts. For the managers Sylvan retained, “the natural response was to go gangbusters in terms of revenues and not spend for future growth,” says senior vice president and CFO Sean Creamer. Sylvan now designs earnouts for three years or more and monitors the deals carefully, sometimes using special audits to make sure the managers aren’t “gaming the system.”

Source: Accessed 9th May 2004

To a certain extent, it depends on which party has the greatest influence over the target achievements. The longer the buyer is in effective control, the more influence, positively or negatively, they can impact on performance.

How large should the earnout be?

Conventional wisdom suggests that earnouts should be limited to 10-25% of the ultimate purchase price. One of the issues which both parties should be aware of is that earnouts are really only appropriate where there is some degree of uncertainty in achieving defined potential targets. If the events or targets were guaranteed, these can be factored into the base price. Where probable outcomes may in fact not be achieved, both parties need to think through the consequences if the earnout is not achieved or substantially not achieved.

An earnout element based on specific large events may be quite reasonable if the final determination cannot be readily influenced by either party. This could be, for example, FDA approval which is awaiting final determination.

This might significantly change the valuation and both parties may agree a significant earnout on the conclusion. However, if the earnout requires active co-operation of all parties and is based on many contingencies, it simply opens the gates to a claim of lack of effort on the part of the buyer.

How should the earnout be calculated?

There is no magic formula for earnout calculations especially those that are performance based. Should they be based on a cumulative achievement or on stage targets? The problem is one of uncertainty for both parties. The seller will want to ensure that payments, once achieved, are not subject to clawback while protecting against events outside their influence, while the buyer wants to reach certain long term objectives.

The biggest problem in all earnout calculations is finding an objective formula that is not subject to manipulation or re-interpretation by either party.

Revenue

May be boosted by promotions, discounts, poor contracts, early shipments, false invoicing, manipulated stage payments, etc. Revenue may also be negatively impacted by cutbacks in allowable marketing expenses, promotion of competing products, interference or delays in completing contracts through approval cycles or newly imposed conditions.

Expenses

Can be reduced by reducing staff, delaying staff replacements, delaying purchases, cutting back on R&D, delaying performance bonuses, buying lower quality stock or components, fighting warranty claims and so on.
Additional costs may be imposed for redundancies, implementation of new systems, additional reporting and budgeting requirements and so on.

Net Profit

Calculations can be influenced by changing depreciation methods, how goodwill is expensed, reclassifying expenses as capital items, excluding some payments as extraordinary items and so on.

Even where the manner of calculation has been specified, there can be alternative calculations. The words ‘According to GAAP’ (Generally Accepted Accounting Principles) need not ensure that a particular method is used if the auditors recommend a change due to legislation or a new accounting standard. Even ‘as applied at the time of the agreement’ will not necessarily cater for an event not foreseen. The terms ‘consistently applied’ are often used to overcome changes.

Setting out the method of calculation during the earnout discussions may help bring out any differences in treatment. The measurement issues become increasingly complex as operations are merged with those of the buyer or central services are undertaken by the parent which results in disputes over transfer prices between entities.

Where competing products are being offered, the earnout may be calculated on both product lines in order to avoid any issue of deliberate bias.

Targets should be kept simple, easily and unambiguously calculated and subject to objective measurement by an independent auditor if necessary. Revenue, for example, is easier to calculate than profits. Specific milestones are easier to determine than profits. Earnouts can be based across a range of events or targets, some financial and others based on specific events.

Example:

SAL’s former shareholders and creditors have an earnout that is contingent upon three events in 2002: 1) an earnout note, due in twenty-four months, for $500,000 will be issued if the SAL Model 5 stepper’s performance satisfies stated stepper throughput and mechanical performance criteria by no later than March 31, 2002; 2) a second earnout note, due in 24 months, for $500,000 will be issued if the combined Model 5 stepper and JMAR X-ray source demonstrates X-ray lithography exposures which satisfy stated performance criteria by September 30, 2002; and 3) a total of 354,736 JMAR shares and an earnout note, due in twenty-four months, for $1.2 million will be issued if an order from a commercial semiconductor manufacturer is received by December 31, 2002 (with pro rated reduction of the payment to zero if the order is received between December 31, 2002 and March 31, 2003).

Source: Accessed 9th May 2004

How should the earnout be paid?

The parties need to agree how the additional valuation created through the earnout will be paid out. Sometimes this is done in cash, other times in cash and shares, or just in additional shares. When shares are used for the earnout, both parties need to agree a formula for how the number of shares is to be determined. This might be at the same market price as for the base compensation, or it might be the price on the day of the payout. Sometimes it is hard to judge where the sellers might be better off. What would happen, for example, if there was a major change in the share price?

Example:

The last round of Nasdaq listings was triggered by the success of Chinadotcom’s listing, which having both ‘China’ and ‘dotcom’ in its name ensured it had a very hot reception.

Who could have guessed at the time that it would trade down from a peak value of $73.43 to a 39th of that ($1.86) at its low?

Source: Accessed 9th May 2004

How much freedom to operate should the seller have?

This is an area of much dispute between buyer and seller. If the earnout is based on operating the business as a continuing concern to achieve the performance targets, this may not sit comfortably with the buyer. The buyer is exposed to expense blowouts, capital project commitments and agreement obligations. Also the buyer will want the business run so that it reduces risk exposure while putting the business on a good footing for the time it takes over effective control.

This potential conflict in interests often results in the acquired business being subject to numerous reporting requirements, expenditure approvals and restrictions on borrowings, capital commitments and so on. Working out the operating conditions and then recalculating the earnout on the new basis can help. It may be appropriate to work out various critical factors such as headcount, expense budgets, capital expenditure allowance, marketing spend and so on.

Example:

Autonomy Corporation plc, a leading provider of infrastructure software for the enterprise, today announced it has entered into a definitive agreement to acquire etalk Corporation, a leading provider of enterprise-class contact centre products, for a purchase price of US$70 million payable in a combination of cash and Autonomy ordinary shares, with an opportunity to earn additional consideration payable in Autonomy ordinary shares upon meeting and exceeding certain future performance-related targets.

Source: Accessed 18th February 2006

A more serious issue is conflict of interest over where the efforts of the newly acquired business should be directed. With an earnout in place, acquired management will have a focus on maximizing their earnout. At the same time, the reason for the acquisition may be to integrate the businesses or to leverage the assets or capabilities across a wider corporate entity. It is difficult to do both at the same time. The most capable people and those with the most knowledge in the acquired business will want to focus on the earnout. However, it is these same people who need to be involved in assisting the roll-out of the newly acquired assets or capabilities.

The new owners have to decide one way or the other. Either they leave the business alone during the earnout or they compensate the prior owners for the time required to work with the new larger entity. This may ultimately result in the new owners paying out all, or most, of the anticipated earnout in advance.

Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.