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Golden Rules for Acquisition Earnouts

acquisition earnout

Many startup founders dream of the day they eventually sell their company for hundreds of millions of dollars, or more. They envision many zeros added to their personal bank account balance as soon as the acquisition officially closes. But many acquirers use a combination of cash and stock as their currency to complete the deal. And some deals even involve earning a portion of the stated acquisition proceeds over time and tied to performance. It’s called an “earnout” and some important nuances about them is the topic of this article.

The Purpose of Earnouts

Most startups prefer all-cash acquisitions. They know some portion of the total amount will be set aside in escrow for payout 12-24 months later, assuming there are no reported violations of the representations and warranties they attested to in the merger agreement. Even getting some portion of the acquisition proceeds in stock isn’t terrible, especially if the acquirer is doing extremely well or already has their stock publicly-traded for easy liquidity.

The topic of earnouts usually enters the equation when there’s a mismatch in valuation expectations between the acquirer and seller. In order for the acquirer to meet the seller’s required valuation, they need the seller to share some of the risk. That’s because the acquirer already must look into a crystal ball and make various assumptions and associated financial projections for years after the acquisition is completed. Even at their proposed valuation, there’s risk the assumptions and projections aren’t achieved.

If the only way to get the deal done is for the acquirer to agree to a higher valuation than they’re initially comfortable with, they might decide to tie a chunk of the acquisition proceeds to future performance. After all, if the results exceed their assumptions and projections, there is room to pay a higher price.  We call this feature a “performance earnout”.

Inexperienced founders might get so excited about reaching the higher valuation that they lose sight of an important nuance – the terms associated with the earnout are really, really important. It follows the adage of “tell me your price and I’ll tell you my terms” (read my article by that same title here).

Golden Rules for Ensuring the Best Outcome

After a serious approach for acquisition, if the only way to reach your required exit valuation is to include a performance earnout component, don’t run away from the deal – especially if you aren’t simultaneously negotiating with other interested acquirers. Instead, shape the earnout provisions to give you the best odds of reaching the required targets and, therefore, earning the additional proceeds.

The basics of an acquisition earnout are simple. If you accomplish A you will get B.  An example might be as follows: For every $5M in revenue above $100M that is generated by the acquired company’s products during the first two years after the acquisition, the seller’s stakeholders will get an extra $2M in acquisition proceeds.

That seems pretty simple, right?  Ask yourself that question again after reading my golden rules that follow.

Short Timeframe

The more time that goes by, the more risk the seller is accepting when it comes to the earnout. I would rather have a reasonable 12-18 month target rather than a longer period.  The longer period does give more chances to reach the target, but the target will surely be considerably higher.

It’s also usually easier to judge how reasonable a short-term target is. Additionally, the more time that goes by, the higher the odds are that the acquirer changes their strategy, adjusts resources, or gets whacked by some negative surprise (recession, CEO turnover, new competitive forces, etc). Additional time equals additional risk to you.

Simple & Measurable

Since future payments to your stakeholders are on the line, it’s important to be able to figure out if the earnout targets were actually achieved. This usually means they are objective rather than subjective, but it also means there must be some way of accurately measuring the stated performance metrics.

It sounds very basic, but let me give some examples so that you can observe the important nuances. Let’s assume your earnout amount is tied to generating more than $100M in revenue from your product during the first year after the acquisition. Simple, right? But what happens if in the middle of the year, the acquirer merges your product into one of theirs? As the newly-combined product is sold, how much of the revenue should be attributed towards your $100M+ earnout target?

Here’s another example. What if your acquirer’s sales team gives away your product (or significantly discounts it) as an incentive to customers that are considering a purchase of another, more expensive, acquirer’s product?

Pursue simple metrics that are, and will be, easy to measure throughout the earnout period.

Exploit Acquisition Synergies

Most acquisitions are driven by the synergies they offer the acquirer. Ideally, the earnout targets are designed to exploit those synergies. What excites you and your acquirer most about having your company inside the acquirer’s company? Are the earnout targets aligned with the acquirer’s overarching strategy and associated business objectives? What would you have wanted to accomplish on your own if you set your sights on a big funding round a year from now at a nicely stepped-up valuation?

Answers to those questions might help identify the synergies that need to be exploited in order to reach the earnout targets and the likelihood that the acquirer will allocate the needed resources to achieve the targets.

Support from the Acquirer

Surely, you’ll need various types of support from the acquirer in order to best ensure the targets are reached. This includes resources, such as headcount and funding, but also possibly other things. Identify the critical support needed and try to ensure it is provided throughout the earnout term. If it’s not provided or gets reduced during the earnout term, then there should be some negotiated recourse that is in your favor.

For this to work, you’ll need to get specific. Getting your acquirer to commit to “marketing support” is not near specific enough. Getting a commitment to spend a minimum of $__ per quarter on demand generation marketing campaigns is specific. Getting a commitment for your team to host a 2-hour sales training workshop for the acquirer’s entire global sales force at their upcoming annual sales kickoff meeting is specific.

Regular Reviews

Insist on regular performance reports that specifically include any earnout-related targets and any committed support items. Quarterly might be sufficient, but depending on the types of targets, it might be easy to produce the reports monthly.

If your systems have the best earnout-related data, it’s fine if your team produces the report. But, in that case, each time you want your acquirer to acknowledge the results. There’s nothing worse than reaching the end of the earnout term and then having disagreements about how the results were measured.

This golden rule also provides the most responsive opportunity to identify changes that cause something to be difficult, or impossible, to measure (per the previously-mentioned golden rule). Catching those quickly gives the best chance to negotiate acceptable alternatives.

Accelerated Payment

If your acquirer plays games or does things that make it impossible for you to reach your earnout targets, there should be a consequence. One potential consequence is for some or all of the earnout amount to be immediately paid (accelerated).

Examples that could trigger acceleration before the end of the earnout period are an acquisition of your acquirer, a breach of commitments made by your acquirer, or termination of your key employees that are necessary for reaching the targets.

Negotiate Details Early

If your acquisition includes an earnout component, that will be stated in the letter of intent (LOI) that is used by the acquirer to formally present their offer (see related article titled “Revealing Company Information Before Getting an Acquisition LOI”). But an LOI is only a few pages long and won’t include very many important details about the earnout component.

You might decide to insist on some additional earnout details in the LOI itself. I’m not suggesting all the details like what is mentioned in this article, but at least enough specificity to dramatically reduce the risk of game-playing during negotiation of the final merger agreement.

Regardless of how much detail you negotiate into the LOI, you want to prioritize continued negotiation and definition of the earnout component early in the due diligence process, while the merger agreement is being drafted and reviewed. Don’t save something as important as this to the end of the merger agreement negotiation.

Summary

Lots of acquisitions include a performance-based earnout component. So don’t freak out if your acquirer wants, or needs, to include one in order to reach your required valuation. Instead, let the golden rules in this article serve as a guide, and make sure to engage an experienced M&A attorney and possibly also a banker (for more on the different types of M&A advisors, read the last section of my article titled “You’ve Decided It’s Time to Sell the Company”). Both professionals are often worth their weight in gold.

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