The Merits, Risks, and Possible Unintended Consequences of Earn-Outs

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When acquiring small to medium sized businesses, buyers often utilize a tool called an “earn-out”, which is a form of contingent consideration that sellers may receive at some point in the future in addition to the cash that they stand to receive at closing. Though earn-outs can be useful and mutually beneficial tools for both buyers and sellers under the right circumstances, without careful structuring and consideration they can fraught with risk and unintended consequences.

Before you propose an earn-out as part of your own acquisition, I’d encourage you to think through some of the risks and considerations that follow.

But First: What is an Earn-Out?

An earn-out can be thought of as a portion of the purchase price that a seller will receive contingent on certain things happening (or not happening). For example, consider an acquiror that has offered to buy your company at a $20M valuation. Instead of paying you $20M in cash however, your acquirer has proposed an $11M cash payment today and a $9M “earn-out” to be paid over the course of the next three years based on the attainment of agreed upon revenue targets. The terms of that earn-out say that, as the seller, you stand to receive:

• A $3M payment after year 1 if sales grow by at least 10% YoY;
• A further $3M payment after year 2 if sales grow by at least 15% YoY;
• A final $3M payment after year 3 if sales grow by at least 20% YoY (for a $9M total earn-out).

Despite a headline valuation of $20M, $9M of the seller’s potential proceeds are at risk via the earn-out, and will only be paid to her if the company achieves the agreed upon milestones. I happened to use revenue as the basis of the earn-out in our simple example above, but earn-outs can be based on EBITDA, cash flow, gross margin, or any number of other variables.

The Purpose of Earn-Outs

Earn-outs can be proposed as part of a transaction for many reasons, but below are some of the more common reasons for their inclusion:

(1) To Bridge a Valuation Gap Between Buyer & Seller: Perhaps the most common reason for the inclusion of an earn-out is to “bridge” a gap between what a buyer is willing to pay and what a seller is willing to accept. For example: If I want to pay a maximum of $10M for your company, but you’re only willing to sell it to me for a minimum of $12M, we may be able bridge that $2M valuation gap through an earn-out. Under the terms of such an earn-out, as the buyer I’d likely propose that I pay you the extra $2M only if the company achieved certain agreed upon milestones after closing (usually the financial or operational metrics proposed as earn-out targets are representative of “best-case scenario” levels of performance). In instances like these, the buyer only pays “extra” for exceptional company performance, and the seller eventually gets her desired purchase price of $12M.

(2) To Provide the Seller with Upside for Exceptional Company Performance: Though the situation above may sound perfectly logical from the perspective of a buyer, all else being equal, sellers understandably tend to prefer cash upfront to any form of contingent consideration, including and especially earn-outs. If a seller is to accept an earn-out, they usually tend to seek some sort of upside as compensation for assuming the additional risk: Extending our simple example above, in response to the buyer’s first proposal of a $2M earn-out, the seller may propose a $4M earn-out instead. This way, if her company does indeed perform exceptionally well post-close, she gets $14M in total proceeds (which is $2M more than the $12M that she was originally seeking) to compensate her for the risk of having accepted this form of contingent consideration.

(3) To Align Interests & Incentives Between Buyer & Seller: When purchasing SMBs, buyers are often (though not always) acquiring the company from their original founders, who often still play a very material role in the day-to-day operations of the company (and even if they aren’t, they almost always have decades of experience, expertise, context and relationships that are extremely difficult for a new buyer to replicate in any reasonable about of time). Indeed, understanding, managing, and mitigating this “key person risk” is a critical consideration in substantially every SMB deal that I’ve ever been a part of. For this reason, earn-outs are often proposed (as are equity rolls and/or seller notes) as a tool to incentivize the seller to cooperate with the buyer post-close, even after she no longer owns the company. Absent this type of economic incentive, buyers run the risk of taking over a going-concern company without the much-needed help of the outgoing CEO. (It’s worth noting here that selling CEOs often genuinely value an orderly transition for their employees and customers even without a financial incentive, but buyers are understandably uncomfortable without having some sort of formal risk-sharing mechanism in place)

(4) To Defer or Finance a Portion of the Purchase Price: Though there are likely better ways to do this, sometimes earn-outs can be a way for a buyer to defer (or finance) a portion of the purchase price, often with a view towards funding the deferred component of the purchase price with cash flow produced by the company in the months and years to come, as opposed to funding it with additional equity upfront. Though debt usually fulfils this role in most acquisitions, expensive and/or illiquid credit markets may force buyers to be more creative in using earn-outs as quasi-debt-like instruments.

Things to Watch out for When Proposing & Structuring an Earn-Out

As mentioned above, without careful structuring and consideration, earn-outs can fraught with risk and unintended consequences. Below are a few of the variables to consider before including an earn-out in your next offer.

(1) What is the Earn-Out Based On?

Though earn-outs are most frequently based off of metrics like revenue, gross profit, gross margin, or EBITDA, buyers and sellers are theoretically limited only by their imaginations, what is measurable, and what is mutually acceptable in selecting an earn-out target. In selecting your own earn-out target, it’s worth considering the following:

• Don’t optimize around a strategically unimportant variable simply because you’re hoping to bridge a valuation gap with your seller. If your investment thesis primarily revolves around growth in profitability, then a revenue-based earn-out target likely doesn’t make much sense. The inverse is obviously true as well. The earn-out target that you select should be indicative of what is strategically important to you going forward. This also implies that earn-out targets don’t necessarily need to be taken directly from the financial statements (though if they’re not, both parties need to ensure that the target can indeed be accurately and objectively measured). For example: If, as a buyer, you are most worried about concentration risk within the company’s largest customer, perhaps you can propose an earn-out target based on a combination of the dollar amount of revenue and the percentage of total revenue generated by that customer 1, 2, and 3 years from closing

• While it’s critical to choose a strategically important earn-out target, buyers must balance this desire against a strong preference for simplicity everywhere possible. All else being equal, in my opinion, simpler earn-out targets are usually better than more complicated ones, even though simpler targets often have their own obvious shortcomings. Consider revenue-based targets, for example: Some people don’t like revenue-based earn-outs because revenue is often seen as a “vanity metric”, and may create incentives for the outgoing CEO to encourage or generate sales from unprofitable or non-strategic customers. Though a profitability-based earn-out could theoretically address both of these risks, simply agreeing on what “profitability” means can be much harder than most might suspect. Anybody who has engaged in a protracted debate with a seller about what “Adjusted EBITDA” truly is can likely empathize. This is the reason why EBITDA-based earn-outs are sometimes referred to as “deferred lawsuits” by those in the legal and accounting professions

(2) Beware of Unintended Consequences

Charlie Munger has famously said “Show me the incentive, and I will show you the outcome” (as if that weren’t clear enough, he’s also said “Never, ever, think about something else when you should be thinking about the power of incentives”).

Generally, people do what they are incented to do, and working towards earn-out targets is no exception. As in our example above, a buyer may be reticent to propose a revenue-based earn-out if the former owner/CEO is running the sales operation immediately post-close, as they are now theoretically incented to accept any source of revenue, regardless of its structural attractiveness or strategic importance (for the purposes of this discussion, we’re focusing only on financial motivators, and ignoring intrinsic motivators like the desire to do the right thing for the company, which we can only hope is the sentiment that ultimately prevails).

Similarly, a seller may be reticent to accept a profitability-based earn-out, because the buyer is usually in control of managing operating expenses post-close, and, at least in theory, they could temporarily inflate operating expenses just enough to avoid hitting a given profitability target and as a result not having to pay the earn-out in question (especially if the earn-out payment is a large one).

Even if you’re convinced that your counterpart is entirely trustworthy and ethical, you’d be doing yourself a disservice if you didn’t at least contemplate the incentives that your proposed earn-out may inadvertently create.

(3) Who Controls the Variable Subject to the Earn-Out?

Closely linked to the considerations above is the concept of control, and specifically the relationship between control and rewards. For example:

• Sellers may be understandably hesitant to accept a revenue-based earn-out if they’re no longer going to be in control of generating revenue after the closing of the transaction. If their ability to collect their reward no longer falls under their control (or under their influence, at the very least), then all else being equal they’re unlikely to accept it

• In a different situation, buyers may be hesitant to propose an earn-out (even if it does bridge a valuation gap) if they’d effectively be paying a seller for the value that they single-handedly created: Consider a situation where there is a valuation gap between buyer and seller, but the seller is planning to leave the business immediately upon closing. Does it still make sense for the buyer to propose a 2-3 year earn-out (to bridge that valuation gap) for the post-close performance that they are likely entirely responsible for generating? If the buyer is primarily responsible for the better-than-expected performance, shouldn’t the rewards accrue to them?

(4) The Earn-Out Payment Itself

Once you’ve decided on the targets subject to the earn-out, and have determined who is going to be largely responsible for the attainment of those targets, you must then consider several variables related to the earn-out payment itself. More specifically:

• Buyers must be clear on how they’re specifically planning to fund the earn-out payment (i.e. where is that money going to come from?). In the best-case scenario, earn-out payments are funded by cash flow generated by the company. However, depending on the size of the earn-out payment and the ability of the company to actually generate the cash in question, that isn’t always an option. If the earn-out payment is to be funded through debt, then buyers must ensure that they will indeed have access to that capital (be careful with lines of credit, as they can be pulled by your bank at any time, and often are pulled during particularly turbulent macroeconomic periods). Buyers must further ensure that adding additional leverage to the company 12-24 months from closing won’t violate any covenants currently in place. Funding an earn-out payment through the issuance of additional equity is often the least preferable option: It is expensive capital, can be dilutive, and can feel less like “better economics for better performance” and more like deferred purchase price

• If the primary purpose of including an earn-out is to align interests and incentives between buyer and seller, then buyers must ask whether the size of the earn-out is large enough to have its intended effects. For example: If your seller stands to make $50M in cash at closing, chances are that a $2M earn-out is unlikely to keep them particularly motivated, despite the fact that $2M is indeed a lot of money in an absolute sense. In a relative sense, the seller is likely to view it as immaterial, and may act accordingly.

(5) What Valuation are you Ascribing to the Incremental Revenue or Profit?

If an earn-out is based on revenue or EBITDA targets (and if the buyer is paying an approximate multiple of revenue or EBITDA), then both buyers and sellers must ask what multiple is being paid for the incremental stream of revenue or EBITDA subject to the earn-out. Consider the following example:

• A buyer agrees to pay $4M for a $1M EBITDA company (implying a 4.0x EBITDA multiple)
• EBITDA is expected to be flat in the 12 months after closing (one of the reasons why the company commanded only a 4.0x multiple)
• To incent the seller, the buyer proposes an earn-out payment of $1M if the company is able to grow EBITDA by $500K (to $1.5M in total) 12 months after closing.

Who is the “winner” in this situation if the earn-out target is indeed hit? Some may say the seller, because she now has $500K more in her pocket than she otherwise would have had. However, I might suggest that the buyer is the real winner in this situation, because they have just acquired $500K of more EBITDA for a 2x multiple ($1M earn-out payment / $500K of new EBITDA), which is half of what they think the earnings of the business are actually worth (4.0x).

Consider a different example that illustrates the opposite:

• A buyer agrees to pay $5M for a $1M ARR software company (implying a 5.0x ARR multiple)
• ARR is expected to grow by 20% (to $1.2M) in the 12 months after closing
• To incent the seller, the buyer proposes an earn-out payment of $1.5M if the company is able to achieve $1.4M in ARR (representing 40% YoY growth) 12 months after closing.

What is “wrong” with this scenario? Nothing necessarily, but if the buyer is agreeing to pay an incremental $1.5M in purchase price for an incremental $200K in revenue, then she must realize that, at 7.5x ARR ($1.5M earn-out / $200K in incremental revenue), she is actually valuing that revenue stream more highly than she originally valued the company’s revenue stream (at 5.0x ARR). As much as that delta could be justified (after all, she bought a 40% growth business when she thought she was buying a 20% growth business), it could just as easily be an oversight, or an accidental incentive for her seller to generate revenue that is less profitable or less strategically important than the $1M of ARR that the valuation of her company was initially based off of.

(6) Will the Seller Demand a Board Seat?

Related to the concept of control discussed above, sellers with material earn-outs often (and understandably) demand a seat on the company’s Board of Directors after closing to ensure that they continue to have some say in the matters that may impact the ability of the company to hit the agreed upon targets. The higher the dollar amount of the earn-out (or the greater the percentage of total consideration that it represents), the more likely they will be to make such a request.

As I mentioned in a previous post, Constructing, Managing, and Working with a Board of Directors, these types of arrangements can and do work well in certain circumstances, but in at least an equal number of circumstances they can prove to be highly problematic. This is so for a number of reasons, including:

• Despite everybody’s best intentions, operational and ownership transitions between incoming and outgoing CEOs often don’t work out as well as was originally envisioned
• If the new CEO has to make changes to the company (especially drastic changes), articulating the need to make these changes to the Board can be much more challenging for the new CEO if the mistakes being cleaned up were effectively caused by the previous CEO
• Sellers understandably tend to be very emotionally connected to their companies, and as a result are often resistant to change, or think that they know better than a young, inexperienced CEO. It is almost always harder than originally anticipated for sellers to watch a new owner make changes to the business that they previously thought of as an extension of themselves.

I’m not suggesting that one should never consider offering a Board seat to a seller (especially if they have a meaningful earn-out in place), but instead that one should be very thoughtful about the potential merits and risks of doing so.

In Sum

Earn-outs can be highly useful and mutually beneficial tools for both buyers and sellers under the right circumstances. However, without careful structuring and consideration, they can fraught with risk and unintended consequences.

Whether you’re using a earn-out to bridge a valuation gap, align the interests of the seller with your own, or defer a portion of the purchase price, your earn-out should be as thoughtful, analytical, and well-constructed as the rest of your offer.

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