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Resources for Sound Business Decisions.™

Earn-Out Agreements: Part 3 – Buy-Side Considerations

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

An earn-out can reduce a buyer’s initial investment, bridge the value gap and provide an incentive for the seller. For the value-oriented negotiator, the primary objective of an earn-out is the maximization of value for both buyer and seller.

Threshold questions include: In the specific instance, is an earn-out really a good idea? And if it is, how do you create a foundation for successfully including one in a transaction?

This article is written from the buyer’s point of view.

When considering an earn-out, a buyer should address the following foundational points before getting into the nitty-gritty detail of negotiations:

  1. Clarify the intent and purpose of the earn-out. An earn-out can be structured to bridge the value gap and/or can also provide an incentive for the seller to hit predefined targets after the transaction closes. As a buyer, you want to be clear about what you are trying to accomplish with an earn-out because that intention will shape the discussions and negotiations with the seller.
    • Bridge the value gap: If the earn-out is intended to bridge the value gap, then the amount of the earn-out is a component of the purchase price. Depending upon the terms of the earn-out agreement, the earn-out amount is a portion of the price that is conditioned upon the attainment of the performance targets.
    • Provide a performance-based incentive: If the earn-out is intended as an incentive only, then any earn-out payments are over and above the purchase price. In this case, earn-out payments are much like a bonus or similar incentive plan, and are not a component of the purchase price.
  2. Determine the amount of the value gap. You need to quantify the value gap before you can begin to bridge it. The value gap is caused by a mismatch between the buyer’s and seller’s expectations and projections for the future. The value gap is the difference between your concept of value and your best guess of the price the seller would be inclined to accept in a transaction without an earn-out, which is not necessarily the seller’s asking price.
  3. Discover the facts and assumptions that account for the value gap. Simply quantifying the value gap does not provide you with sufficient information to craft an earn-out that meets the objective of maximizing buyer and seller value.
    • Dig into the facts and assumptions upon which the seller’s projections are based. You want to fully understand the story behind the projections: the goals, strategies and action-steps that form the seller’s future vision and business plan. Understanding the seller’s assumptions doesn’t imply that you are in agreement with them—it just means you comprehend them.
    • Determine if the seller’s assumptions and projections are “reasonably” achievable. The seller’s business plan and projections can be based upon a pipe-dream or can be both realistic and fundamentally sound. If you think the facts and logic behind the seller’s assumptions are specious or unrealistic, then going any further with the earn-out is an invitation for future conflict.
    • Consider whether the seller’s direction is one that you want to pursue as a new owner. It is possible that the seller’s plans are feasible, but not a direction you want to pursue. In this case, pursing an earn-out can be a set-up for future conflict and friction.
    • Determine the additional risks associated with the seller’s assumptions and if they increase the enterprise risk. When discounting future earnings or cash flows (income streams), the key variables are the income stream and the discount (risk) rate. You want to compare the relative risk between the two business plans and, if necessary, work the additional risk into the overall discount rate and value concept.
    • Consider how much the company would be worth if you used the seller’s more optimistic projections (with the same valuation metrics you applied to your projections). By determining the additional earnings and discount rate of the business based upon the seller’s projections, you can create a “what if…?” value. By deducting the value based upon your projections and the seller’s “what if…?” projections, you have a number to work with in setting the earn-out performance targets and payout rates.
  4. Consider whether the company will be operated as a standalone business, closely integrated into an existing business unit, or merged into another business. When negotiating an earn-out, it is important to define the “business.” Such a definition is clearer when the company will be operated on a standalone basis. However, isolating the various performance targets becomes increasing more difficult when the acquired business is merged, tightly integrated or completely assimilated by the parent. It is also requires additional accounting and reporting to distill the performance target from the overall entity. Despite the difficulty, if an earn-out makes sense, these issues can be addressed during the negotiation process.
  5. Share your vision for the company’s future and the detail of your business plan with the seller, and determine if the seller is aligned with them. If a transaction closes, you are going to have an on-going relationship with the seller. The seller is going to be a stakeholder in the company’s future and might even have an active role in the management and operation of the business. Incongruent visions will result in conflict, especially if the seller is a strong alpha personality.
  6. Consider the role you want the seller to play in the company’s post-acquisition future. So, assuming that you and the seller are congruent with the vision of the future, the next issue is to define the seller’s future role, if any, in the business. The seller may or may not want to have a continuing role. And, you may or may not want the seller to be active.
    • If the seller is going to have an active role in the management of the company, consider whether the seller’s management style is consistent with yours. If the seller is not someone you would want on your management team, then you obviously don’t want to go down that road. If you hire the seller and then feel obliged to terminate employment, there is going to be hard feelings and, depending upon the terms of the agreement, possibly a payment to be made to the seller.
    • Consider the degree of control and authority you’re comfortable giving a seller over operations, accounting and capital budgeting matters. When it comes time to negotiate the actual details of the earn-out, control is going to be a big issue. The seller is going to want to do everything possible to protect their earn-out payment. On the other hand, as a buyer, you want to retain all of the rights and authority necessary to protect your investment.
  7. Think about your chances of reaching a clear understanding with the seller on your major post-acquisition operational, accounting and fiscal policies. A lack of clarity on these issues is a breeding ground for disagreement. If you can’t discuss these issues and reach a good understanding with the seller, then negotiations can reach an impasse or, even worse, you will set yourself up for trouble by glossing over these points in favor of just getting the deal done.
  8. Quantify the financial impact of the seller meeting the performance targets. If project-based targets are to be included in an earn-out, you want to quantify the financial contribution that these projects will add to the bottom line and cash flow. In addition, you want to thoroughly understand any expenditures and additional investments that might be necessary to complete the project. You want to factor these items into your projections and discounted cash flow calculations to make sure that the additional risk and amount paid meet your hurdle or threshold rate for ROI on the additional investment.

The above steps provide a framework for evaluating whether an earn-out makes sense in a particular situation and lay a foundation for negotiating one that will maximize value for you and the seller.

In many ways, an earn-out negotiation is like an employment interview in which both parties do much better when they focus their discussions and questions on the job’s requirements and abilities of the candidate to successfully perform his or her duties. After the parties are comfortable with each other and want to pursue a relationship, then issues like compensation and benefits naturally come into play. Trying to negotiate a “dumb number” without reaching a meeting of the minds about the underlying assumptions is putting the cart before the horse and may not get you where you want to go.

Next Edition: The next edition will look at the issues a seller needs to face before getting involved with the complex, time-consuming and expense-incurring, formal negotiation process.