• April 24, 2010
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Earn-Out Agreements: Part 4 – Sell-Side Considerations

Note to the Reader: This is the fourth in a series of articles that explore the definition, application and issues of including earn-outs in negotiated M&A transactions.

In the last installment of this series, we explored the buyer’s considerations when deciding whether to propose an earn-out agreement to a seller. In this article, we will look at the issues a seller needs to face before getting involved with the complex, time-consuming and expense-incurring formal negotiation process.

An earn-out is frequently proposed by the buyer, who is concerned about conserving cash, reducing the need for debt, mitigating risk and incentivizing the seller by making a portion of the purchase price contingent upon the attainment of pre-defined performance targets.

While the advantages to the buyer are clear, an earn-out proposal runs counter to a seller’s general financial objectives which are to get the highest possible price, with the most cash up-front and, in many instances, as little future risk as possible. Plus, even if a seller has been active in the management of the business, he or she may be motivated to sell in order to retire. This tension between a seller’s and buyer’s objectives, sets the stage for negotiations.

Within the context of the negotiation, it is reasonable to assume that the buyer is evaluating several investment opportunities and uses for its funds (i.e., other acquisitions candidates, projects providing organic growth or dividend distribution). On the other hand, it’s equally likely that the seller is going to be evaluating proposals from several prospective purchasers.

So, from a sell-side perspective, an offer containing an earn-out may be one of several different offers a seller will entertain, and they will possibly be entertained simultaneously. Just like the buyer who decides which investment opportunity among several is the optimal blend of risk, reward and strategic congruence, the seller may have to decide which buyer proposal is ultimately going to be accepted and pursued.

Sell-Side Situations that Suggest an Earn-Out

If a business falls into any of the four groups listed below, it should not surprise a seller if a buyer(s) wants to add the element of an earn-out into the deal. That doesn’t mean that a seller should necessarily announce that they are seeking an earn-out, it just means that the conditions suggest the subject may be raised.

1. Businesses in the development or entrepreneurial stage with limited operating history.
2. Companies that have introduced (or plan to introduce) a new product line or technology that does not have a track record as of the date of negotiations.
3. Turnaround situations in which the future existence of a business is in question. The focus is on survival and the business may not be generating positive cash flow.
4. Markets or industry sectors that are experiencing growing valuation multiples that may be reaching a peak (and buyers are indicating resistance).

Putting an Earn-Out on the Table

A buyer can introduce the idea of an earn-out in of one of two ways: the buyer can bring it up during discussions (a trial balloon) or present it as a component of a written proposal (offer or letter of intent).

1. The Trial Balloon: The buyer can float a trial balloon during discussions by either asking the seller outright if they are open to an earn-out or by indicating that they are interested in making an offer as long as it includes an earn-out provision. The buyer is attempting to position you toward an idea without committing to anything.So how do you respond to the trial balloon? The seller can dismiss the idea or indicate interest. My response is to neither embrace nor reject the idea, but rather indicate something to the effect that: “we are interested in all serious proposals and will look forward to your proposal.” My reasoning is based upon two points. First, never negotiate with yourself. Secondly, until you see a written proposal, you have no idea what kind of total purchase price package the buyer is going to offer. So, conceding an earn-out without knowing the specifics of the other deal terms, is giving ground for nothing in return.
2. The Written Proposal: Sometimes a buyer introduces the concept of an earn-out by including one in the terms of the written letter of intent. The LOI provides something concrete for you to discuss. It will provide the terms of the overall purchase price package along with the general terms of the earn-out. A written proposal indicates serious interest on the part of the buyer.

Possible Reactions to an Earn-Out Proposal

The general question of whether an earn-out is something of interest to a seller brings into consideration the objectives of the seller, the seller’s concept of value and the seller’s relative bargaining power. An offer with an earn-out provision should be objectively discussed with the seller and his or her advisors. In essence, this discussion boils down to: does the seller want to consider an earn-out and, perhaps more importantly, does the seller need to consider an earn-out in order to get the right deal, or for that matter, any deal?

So, imagine that the business is on the market, buyers are kicking the tires and one such buyer is interested enough to introduce the topic of an earn-out into the discussions. The seller can react several ways:

1. Dismiss the idea and give it no further thought on the grounds that they are “just not interested in an earn-out. I don’t want one and talking about one is a sign that we are wobbly on price.”
2. Look at the top-side of the number and enthusiastically lock into that number because it is close or possibly exceeds the seller’s aspirational price.For example, the owner is looking for a number of $5,000,000 and the buyer offers $5,000,000 to be paid 50% cash and the balance contingent upon the attainment of a financial metric (that was pulled from the seller’s own projections).
3. Study the idea with objective detachment to determine if the seller wants to have an earn-out relationship with that particular buyer and approach discussions accordingly.

When a serious and capable buyer broaches the topic of an earn-out, we recommend that a seller take an objective look at the proposal. A seller can reject the idea, but the rejection should be based upon a rational examination of the facts and not on the basis of emotions—positive or negative. So, our vote is for option 3—pause and reflect before deciding.

The Right Deal, Wrong Buyer: It is conceivable that an earn-out may make sense as a way to enhance the overall valuation, but that it is not a good idea with a specific buyer. The reverse may also apply. A seller may be averse toward earn-outs in general, however, when an earn-out is introduced as a component of a purchase price package by a specific buyer, it may make a great deal of sense.

An Earn-Out is More than an Agreement. It’s a Relationship.

The various terms and conditions of an earn-out are set forth in an agreement. However, an earn-out is more than an agreement. An earn-out is a relationship between the buyer and the seller. The terms and language of the agreement should be carefully and diligently drawn. However, the terms are not the relationship although they do define the boundaries. The earn-out agreement defines the rules of the game. Assuming that those rules were negotiated in good faith, it’s up to the players to work with those rules so that their common purpose—the performance targets—can be achieved so that both parties increase the long-term value of the transaction.

Threshold Issues for a Seller to Consider.

Before dismissing the idea or embracing an earn-out proposal, do some fact-finding about the buyer’s assumptions. The following list is written from a seller’s point of view and systematically addresses the threshold issues of whether or not to enter into active negotiations over the details of an earn-out.

1. Discover the buyer’s assumptions that account for the value gap. When the buyer presents an offer with an earn-out component, you now have several important pieces of information:
   • Your concept of value as a seller.
   • The total price of the buyer’s offer (all forms of consideration including the earn-out component).
   • The portion of the offer that is made up of cash, notes, and stocks. You want the buyer to be financially committed to the acquisition. As a seller, you don’t want to be promised “monopoly money” in exchange for the keys to the business (unless you are under a compulsion to do a deal—any deal).
   • The portion of the total offer attributable to the earn-out. The larger the percentage of earn-out, the greater your risk.
2. Discover the buyer’s stated reasons for including an earn-out into the deal structure. There are a number of reasons why a buyer would gravitate toward an earn-out. As stated earlier, an earn-out conserves cash, reduces debt, provides an incentive to the seller and lowers the buyer’s risk. A buyer can also be offering an earn-out because they are short on cash or debt capacity and that is the only way they can get the deal financed. In either case, it is helpful to understand the buyer’s intentions and the implications.
3. Find out how the buyer established the earn-out amount and key terms. At the letter of intent stage, the key metrics of an earn-out are the performance target, the payout formula and any minimum or caps on the payment. As a seller, you want to understand how the buyer arrived as these items. Do you agree with the buyer’s thinking? Based upon your understanding of the business as it is currently being operated, are these metrics attainable?
4. Your role, if any, in the management of the company after the transaction closes. When you accept an earn-out, a potentially significant portion of the purchase is contingent upon hitting the performance targets. This amount is at risk. The management of the business after it is acquired is going to determine whether the targets are hit or missed and whether you get paid or not.
5. So, to the degree that you can exert influence over the success of the venture, you can minimize risk. The key questions are: do you have the ability to meet the earn-out targets? Do you actually want to be involved in the management after the deal? Can you see yourself working for the buyer? In some cases, an owner was passive before the sale or is motivated by retirement to pursue the sale. So, would you (or should you) now become active with the company for the sake of realizing the potential of an earn-out?
6. Learn as much as possible about the buyer’s vision and plans for the future of the company. If the deal happens to close, you will have an entirely new relationship with your former business. Instead of having control of the business as an owner, you will become what is effectively an investor in the post-deal business. The control over operations, policies and treasury will pass to the buyer. Do you think the buyer has the commitment and ability to attain the performance targets? If you’re going to have an active role in post-acquisition management, do you think the performance targets are realistic and, more importantly, what degree of support do you think you can expect from the buyer to do what is necessary to hit the targets? You will be hitching your wagon to the buyer. So, be sure that the buyer has what it takes to get you where you want to go once the transaction closes.
7. The degree of integration of the seller’s business into the buyer’s business. After the acquisition, your company can be operated as a standalone business, provide the buyer with a platform for growth, or rolled-up or merged into another business. It is very important to understand the actual business and the targets upon which your earn-out payment will be dependent.
8. Merging or combining your business with another can be attractive for the buyer. However, it will require careful negotiation and definition of the earn-out formula along with the issues of control, accounting and financial reporting.

Now there are other points to consider and discuss in the process of arriving at a definitive earn-out agreement, however understanding the buyer’s assumptions will help the seller decide if the earn-out proposal is something they really want to pursue with the particular buyer.

Keep Your Objectives in Mind

As a seller, your objective is to maximize your chances of meeting the earn-out performance targets and earning the contingent portion of the purchase price without getting into a head-knocking contest with the buyer or its representatives. You can’t reduce the risk to zero, but you can minimize it by understanding the implications of an earn-out and having experienced professionals on your team. Negotiating a sound agreement is essential, but your primary objective is to get paid.

One closing thought; this series of articles is intended to stimulate thought about earn-outs from a businessperson’s point of view. Earn-outs can be fickle creatures. ALWAYS have legal, tax, accounting and deal professionals with previous earn-out experience on your team to handle the complexly delicate aspects of negotiating and codifying an earn-out agreement.