Lesson #146: Pitfalls Around Earnouts (and Why They Rarely Payout)

Following up on Lesson #145, issues to consider before selling to big companies, I wanted to drill down deeper on earnouts, and potential pitfalls to avoid, as earnouts rarely payout as expected.

First of all, what is an earnout?  An earnout is typically a performance-based payment that has been agreed to be paid to selling shareholders, above and beyond any payments received upfront at closing the deal.   So, for example, let's say a buyer is willing to pay you $1MM upfront at closing, and up to $4MM additional proceeds if your EBITDA exceeds a certain level within one year of closing.  That $4MM part of the deal, is the earnout portion, tied to future performance of the company.

Earnouts typically never pay out they way a selling company is hoping they will, emphasizing the importance of making sure you are 100% content with the upfront proceeds only, in the event the earnout payout ends up being zero.  The reason earnouts rarely payout as planned are numerous, including:  (i) the way it was actually written, which can end up benefitting the buyer; (ii) the buyer is not naturally motivated to have their behavior drive additional proceeds to the seller; (iii) typically, the pace of business post a sale is materially slower than life before the sale; and (iv) unexpected things can happen, that may or may not be in your control.  I will address each of the points below.

The devil is in the detail, in terms of how an earnout gets written.  The first issue is whether it is driven by future revenues (which is in seller's benefit) or future EBITDA (which is in buyer's benefit).  Revenue is 100% clear and clean, but buyer's do not want sellers to load up marketing losses tring to juice up revenues to get a higher payout.  And, on the flipside, sellers should be wary of an EBITDA based earnout, because after they sell the company, there could be a lot of corporate expenses which may be pushed down to your divisional level, that hurts EBITDA and the earnout.

In addition, earnout payment calculations can be manipulated by other things, like making adjustments for any net working capital changes of the company.  And, balance sheet movements are a lot harder to control than income statement movements.  For example, you can't control how fast your vendors pay your accounts receivable owed to you, meaning any inflation in your collection time, could decrease your earnout payment.  Same type of thing around any capital expenditure based adjustments, where any monies you spend on needed asset purchases to drive your growth, could also end up hurting your expected payout.

And, let's face facts, a buyer is typically more than happy to wait a year before investing a lot of their promotion support in your business (which you are most likely hoping for to drive the earnout).  From a buyer's perspective, why pay $5MM for a business, when they can pay $1MM, with no additional earnout payments made.  So, unless you detail otherwise in your agreement, don't expect the buyer to be doing a lot of sales or marketing favors for you doing the earnout period. 

Or worse, protect yourself from the buyer loading up a lot of expenses during the earnout period, which can hurt your payout.  For example, sales & marketing expenses today, which will help long term growth of the buyer, will typically come at a loss during the earnout period until the future revenues are driving for the buyer well after the earnout period has ended (great for them, horrible for you).

And, as mentioned in Lesson #145, when selling to big companies, don't expect the way things operated for your company will be the same after the sale.  Typically, the pace of business will get a lot slower, based on both new corporate tasks required and the slower decision making process of bigger companies.  So, you may not be swimming in a pool of water any longer, you may be swimming in a pool of molasses.  And, any slowdown in pace, could impact your ability to maximize the earnout payout.

Then there is the list of all the unexpected things that could happen during the earnout period, which can hurt the payout.  Perhaps there is a big hit to the economy, like there was around 9/11/01.  Or, some hurricane wipes out your home office in New Orleans.  Or, your salesperson is "cooking his books", to drive more commissions, to only find out the contracts were never real too late in the earnout period to actually make up for the unexpected shortfall.  This last point actually happened to one of my businesses, during its earnout period, costing the shareholders around $3MM of additional proceeds!!

So, as you can see, I am pretty bearish about earnouts.  But, sometimes you have no choice, in order to get your shareholders a reasonable way to acheive their ROI objectives.  So, when you use an earnout structure, make sure: (i) it is "iron clad" in its drafting, so no confusion and no opportunities for the buyer to manipulate the calculation; (ii) negotiate for the buyer to bring full promotional support day one, at no impact to the payout calculation; (iii) make sure you are realistic on what life will be like post the sale, to make you are still happy with the deal with slower growth assumptions; and (iv) make sure the business is largely run as-is until the earnout period is ended, to prevent any unexpected buyer expenses, decisions or process from negatively impacting the earnout.

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