Understanding Earnouts

If/when you sell your firm, it’ll likely be the largest transaction of your life, and so it makes sense to understand it! In this episode David gives a crash course in everything earnouts.

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"Understanding Earnouts" by David C. Baker for punctuation.com

Transcript

Blair Enns: David, our topic today is Understanding Earnouts. What is an earnout?

David C. Baker: First of all, let's just clarify that the audience has been clambering to understand earnouts.

[laughter]

The numbers drop.

Blair: Yes.

David: An earnout is when you sell your company, it's split into two parts. You get a certain amount of cash at closing. Then the second part, everything you don't get in cash at closing, is an earnout, and that's what you get over time if you hit certain performance targets. If you are selling your firm, it's probably the only time you'll do it. It's probably the biggest transaction of your life. Everybody knows what an earnout is, basically, but I'm trying to give people a 25-minute seminar on earnout so that they go into that possible transaction a little bit more intelligent about what's going on.

Blair: Point of clarification. If I never sell my business, nobody is ever going to give me an earnout, correct? [chuckles]

David: You did not have to say that at the beginning of an episode, but that is absolutely true.

Blair: All right.

David: It's an incentive.

Blair: It's an incentive if you sell your firm. I'm trying to have fun with this topic. You and I have been in this business a long time, well over 50 years combined. I remember way back people started selling firms, and earnout was like, "Oh, yes, it's a whole bunch of money but it's on an earnout." Then you'd think, "Well, good luck to you." Tell us a little bit about the history of earnouts without boring the shit out of us. It hasn't always been this way, has it?

David: No, it hasn't. There have been earnouts in our industry for at least 40 years, like there have been earnouts elsewhere, but they've changed significantly. In the history of earnouts, if we go all the way back to Abraham's lemonade stand, that's where entrepreneurship started. There were no earnouts. You bought a glass of lemonade for Abraham and you got paid. In the history of business, earnouts are a very new thing, like from really the '80s on. They've been true in our field as well. They've changed significantly. Now they're three years at the most, sometimes two years, sometimes one-year, sometimes you get all the money in cash at closing.

In the past they were five years. Earnouts didn't come along until about 40, 45 years ago, and it wasn't driven by buyers, oddly enough. You would think that buyers would say, "Listen, I want to protect my downside if this goes bad," but that wasn't really what happened. It was investors that were behind the buyers that said, "Okay, buyers, you want to start paying more for companies, we get it." Now you're saying, "Okay, we're going hedge out bet, and we're going to pay more for companies," but the more we're going to pay is going to come at an earnout."

These investors behind the buyers were saying, "Listen, we got to have a little bit more structure here. We have to have a little bit more certainty. We have to have these things structured very carefully." Which was a benefit to the buyers and the sellers too, because they benefited from knowing more about that. Earnouts are the last 45 years. Before that they didn't happen very often.

Blair: We went from no earnouts to five-year earnouts and then that timescale seems to have scaled back? It's now one to three years, is that correct?

David: Right. Every once in a while we'll have a deal that we do where there's very little of the purchase price paid in an earnout. Like we did one, I think, it was three years ago where we were representing the buyer. The person selling the firm was going to have an appointed post in the US government. They could not have any conflict of interest, and an earnout is a conflict of interest, because the seller would have some incentive to send business his way in order to get the most, and that couldn't happen, and so we had to structure it.

That happens every once in a while. When you sell to a client, like if you have a client concentration issue, and you sell your firm to an existing client, there is not an earnout there, but in almost every case there's an earnout. It's never more than three years and sometimes it's shorter. Sometimes the earnout doesn't have to be the same for each partner. They can be different based on what the buyer is looking for.

Blair: You want to walk us through the basic elements of an earnout? One of them is the time period that we talked about.

David: It's really pretty simple. There's the time periods, so how long will this last? The second would be the formula for calculating the payment. The third is any dependencies, like what has to happen for you to get this earnout. I just want to pause and say, the M&A market is so much better in almost every respect than it used to be. This is another area in that the earnouts, not only are they shorter, but they're so much simpler. You don't have these complicated spreadsheets about how you get them and accelerator clauses and all this stuff. It's like, "No, this happens and this happens," so it's much simpler, but it's always involving those three things. What's the formula, what's the time period, and what are the dependencies in order for you to earn this? That would be the basic structure.

Blair: The formula's typically based on, maybe this is the dependencies. It's usually a measure of, is it top line revenue, bottom line, or somewhere in the middle, gross margin? One of those three things?

David: It all depends on what the buyer is nervous at all about. Sometimes it's top line. Sometimes it's bottom line. Sometimes it's neither. Sometimes it's just growth rate that you maintain. Sometimes it's retention of a certain client base. Sometimes it's like, did you get this approval? Did you get a registration with a patent and trademark office through that helps retain the value of this asset that we're purchasing and so on? Usually, it's tied to something around profitability because profitability, unless it's a strategic purchase, is what's going to drive an acquisition price. They just want a little bit more certainty around profitability, so often it's tied to that too.

Blair: In your most recent book, Selling Your Professional Services Firm, you talked about earnouts. I think you told a story about the earnout dependency was not tied to the overt reasons for the purchase. Am I speaking about that correctly?

David: Yes. That's why in the early conversations that you have with a potential buyer, if you're selling your firm, you want to nail down, like, why are you doing this and why are you choosing our firm? You memorialize that so that you're all agreeing like this is driven by such and such. In the example I think you're referring to, it's like, "We're a coding firm and we need a recruiting presence in Austin." That's one of the things that's driving this acquisition. You record this and you memorialize it, and then later during the negotiations, they start beating you up because you're not all that profitable. Then, you have to remind them it's like, "But we're still in Austin."

That was what was driving this thing. You have to memorialize that and surface it early on. This is where you have to be really careful about aligning the incentives with what you think the company is going to ask of you. Let's say that they're nervous about the profitability path that you've been on. Well, they're not nervous about it because you've demonstrated, but they're nervous about whether you can keep it up. They say, "Listen, we're going to keep the books on your firm separate and your earnout is going to be dependent on your continued profitability."

What you love about that is you have all kinds of control over that, and you're not worried about hitting those because you know your firm really well. Now, the transaction happens. Now, they see how successful you are, and they see how you could impact other areas of their business. They start asking you to help, and because you're a team player, you say, "Sure." Then it dawns on you like, oh, wait, my earnout is not dependent on how these other divisions do so how does all that play in? Especially if I start to take my focus off of the company they purchased and I focus on helping other departments, how's that going to help me?

You have to think far ahead. Either that or you have to have a buyer who's open to changing these arrangements so that the incentives align with where they're asking you to focus. It's a big game you have to think about, and that's where an advisor can help you think through what they're going to expect of you. If you don't think that the prospects that you have on your own are very strong, well then, you're going to fight for an earnout that's tied to the overall performance of the bigger company. That gives you the freedom to not focus exclusively on your little sandbox after the acquisition, but to help the bigger company. In some cases, that's really in your best interest anyway.

Blair: That's interesting. Let's say I've acquired your firm and you're on a three-year earnout, and your earnouts are tied to certain metrics. Then I say, "Hey, David, can you spend a little bit of time and attention on this other thing?" Taking your time and attention away from the metrics which will drive your financial return. You say to me, "Go get stuffed, Blair," because basically, I'm going where the money is. From my point of view as the acquirer, you're not fully in my employ at this moment. I translate this to the owner of an agency saying to a salesperson who's on full commission, "Hey, I want you to take more time and be more diligent in completing the CRM or attending these meetings." That person's response is, "You know what? I eat what I kill. You don't pay me to be in meetings, therefore I'm not going to be in meetings. You don't pay me to update the CRM, therefore I'm not going to update the CRM."

David: Exactly. There's this inverse relationship between the degree to which the purchase de-risks your situation, and whether or not you are in the full employ of this other company. It's like, "Okay, if you're paying me 100% cash at closing and there's no earnout, then, yes, I'll do whatever you need. I'm at your beck and call."

Blair: I could also leave.

David: I could also leave and kill the whole thing. To whatever degree somebody is retaining risk and that's what the earnout is, then you as a seller have a really strong incentive to define that really, really carefully, and to hopefully have a good relationship with the buyer so that you both agree, "Ah, this just isn't working quite the way either one of us thought. Let's redo this." In many scenarios, those things are looked at again and are revised, which is the way it should be.

Blair: Things change on the ground. The acquirer wants the CEO of the firm that's being acquired to change his or her attention to something else. The incentives aren't aligned, so they agree to realign the incentives. That's not uncommon?

David: Not uncommon. No, not at all. Especially in a relationship that hasn't gone bad. If the relationship is still good, it's very common. When you change the arrangements of an earnout, you don't want to make it more complex. You want to retain the same simplicity, but just shine the spotlight in different areas. I firmly believe, but I don't have data for this. You might because of your experience on the sales side, but I don't think that complex incentives motivate people. I think they need to be pretty simple. When I think of my dog, for instance-- oh man, really, every time I say this. I really need a new example.

Blair: A new dog? [laughs]

David: I need a new dog too.

Blair: You need a third dog.

David: One of my dogs is good. When my dog does the right thing, I give him a treat. I don't add up everything and then balance things out and then on Sunday afternoon, we even out and decide what he really earned in the week. No. Complex incentives don't motivate even humans. You still need to keep this thing simple. You just redirect where the attention is.

Blair: The rule of thumb in sales compensation is A, the incentives has to be simple, and B, the reward has to be as close to the behavior as you can get it.

David: Right, exactly.

Blair: That's why a five year earnout seems a little bit ridiculous to me. When you said earlier that things in the M&A space are getting better, these deals are getting better, part of what you meant is that the incentives and these earnout structures are getting simpler. Is that correct? Simpler and shorter?

David: Yes, simpler, shorter. I wouldn't say that we're getting a larger percentage of the sale price in cash at closing, but what isn't coming in cash at closing, is coming faster and simpler. Those are both good.

Blair: Got you. You hit on a few things that earnouts are tied to, like top line revenue, profitability. I think you said growth trajectories. Anything else in there you wanted to touch on?

David: If I could just call out a danger here. Usually the specific incentive that gets suggested to you as the seller, so we know there's going to be incentives, we know there's going to be an earnout, but we don't really know what it's going to be tied to yet. When you first hear the specifics, it's usually in response to some bad promise you made to the buyer, where the buyer is raising a question.

It's like, "Oh man, three years and two years ago, things were great, but there was this fall off." You say, "Here's why it happened. It won't happen again," and yada yada. Or, "You've had great results recently, but they've been tied to this certain thing. Will that continue?" You assure them that it will. You need to be really careful about those promises that you make because it's really easy for the buyer to flip around and say, "Ah, that makes sense. Why don't we just build that into the earnout?"

Now you have to eat whatever promises that you've made. You want to be super careful about that. Whenever you make some big lofty promise, you need to be willing to back that up with some sort of an earnout. You just really want to be careful. The earnouts themselves are pretty what you would expect. Top line revenue targets, profitability, maintaining a certain level of growth, retain a certain client, or even milestones that you need to reach. Maybe a software product needs to receive this level of penetration in the market or whatever that is. They're all pretty simple. Usually it's not a combination of all of these things. Usually it's one or two, maybe three things at the most.

Blair: Got you. I worked for a guy who had a three year earnout and he ended up earning-- I don't know how to say this because it's not like I was on the inside of the deal, but everybody heard what the numbers were and in the end he ended up earning more. Is that even possible?

David: It's quite possible. Usually the sophisticated buyer will have a formula in there and there'll be some sort of a cap on it to prevent that from happening. That's also the most likely time the buyer's going to come back to you and say, "Hey, can we renegotiate this a little bit?" It does happen for sure. Even when it doesn't happen in the earnout, you'll find that to be true frequently if the seller has agreed to not get 100% of the purchase price, but to turn some of that into rollover equity. Where they say, okay, we'll allocate 20% of what we would've paid you in shares or stock or something like that, in the acquiring entity, and so you get sort of a second bite of the apple.

Frequently there's a lot of risk associated with that, obviously. When that happens, it usually means you're going to get quite a bit more money. You have a strong incentive as the seller to do a lot of research on the buyer's prospects too, because you're not going to get that money unless they hit their target. It's pretty frequent and it's a beautiful thing when it happens.

Blair: Some of these earnout targets, they're not hard numbers. They're not pass/fail, zero or 100.

David: They are when you first get them frequently, and that's when your advisor needs to push back and say, "Hey, if we have to hit 18% profitability or something, and we've only been at 11%, what if we hit 17? Are we going to get nothing?" That would be a cliff target. That's where the advisor's going to push back and never let you agree to that and say, listen, these need to be graduated. Maybe they can be algorithmic so that they're not straight, but they need to be graduated so that you still get something. You get some proportion. If you hit a proportion of the goal, you should get a proportion of the reward. The big point is you need to turn those cliff targets into graduated targets.

Blair: Earnouts are almost always tied, or maybe even always are tied to employment agreements where they should be. Is that right?

David: They should be. They often are not. In many cases, the employment agreement never comes up unless there needs to be some non-compete.

Blair: "Dude, you didn't hit your target, you don't get the earnout." "Well, you fired me." [laughs]

David: Yes, exactly. This is one incentive that the buyer has, to have shorter earnouts, because the earnout should be matched with a corresponding employment agreement. If I sell my firm and my earnout is three years, then I should be employed at that company where I have sufficient influence to hit the target.

I can be fired for cause at any point, you can't reverse that necessarily. Otherwise, I should have a job, I should have the influence to help hit this target. I need an employment agreement, which means you need to know how much money you're going to make. You need to know what your responsibilities are, you need to know what those carve outs are and so on. Always think about an employment agreement having to match the length of the earnout, or it's going to be very difficult for you to hit those targets.

Now, in most cases-- well, I'm not sure I should say most cases. I would say roughly half the time after the earnout expires, the seller is ready to move on for whatever reason. They're at the end of their career or maybe they want to do something else or whatever. Then the other half the time, they really love it there and it turned out to be great. They want to re-up their employment with the company and the company wants to keep them. We're not talking about that period where both parties have to agree.

We're talking here about the fact that there is a guaranteed employment agreement, and the only way that the buyer can get out of that is for cause, like you steal or whatever. Really bad things.

Blair: As you're talking about that, I'm recalling a client of mine, she sold her firm for bucket loads of money. Then when she gave me the details, she said, "It's a five-year earnout." I went, "Oh, you poor thing." She said, "No, no, I asked for it." She wanted to continue to work for the firm. I have a hard time getting my head around that, but that still happens, doesn't it?

David: Yes. It usually happens because they've done the entrepreneurial thing. They actually did pretty well or they wouldn't get an offer, but they love being a part of a bigger company. They like to play on a bigger stage. They like the fact that new business is a very different game for a big company versus a small company. We helped sell a firm from San Francisco to New York. Two women, one of them departed right after her earnout, and the other one has risen in the company's ranks and absolutely loves being a part of a bigger company. It's just how each of them approached it and where they were in their individual lives and what they wanted to do. That's another case where the sellers don't have to have the same approach to this. They can make different decisions.

Blair: What's the big reversal?

David: There's some risk associated in selling your firm. The risk is all associated with the earnout, because you don't have that money yet. What if something happens at the firm that is buying you, and maybe you've done your due diligence, but something outside of their control happens, and they start missing payments to you, or whatever those promises were? That does happen. If that happens when we're the advisor, we want to specify what happens in that case. What we want to make sure is that you get to keep the money that you've got, your release from your non-compete, you can do what you want with the clients that you took with you to that company, and so on.

It's not ideal because you didn't get the earn-out, or at least all of it, but at least your life isn't over, and you can start over, and you've kept some money from that transaction. Very few of these agreements account for that because they just assume that things won't go bad. We like to cover that base.

Blair: Have you been involved in some deals where things did go bad after the acquisition?

David: Oh, yes, absolutely. It wasn't anything either we, as the advisor, or the seller could have anticipated, but yes, absolutely.

Blair: This stuff happens.

David: Exactly. Especially in this world, where a company can be very strong on a Thursday and then be gone the next weekend. We saw some of that with some of these investment firms.

Blair: Yes, we were talking about that before we hit record. All right. Do you want to summarize the key points of understanding our notes for the audience?

David: Yes. This is meant just as an overview for people, but these are the big questions you want to think about. Does the earnout that you're presented with incentivize the right things? Will it be easy to calculate? What will happen if you don't hit the desired target, like that big reversal? Will it allow you to de-risk the ownership of your firm? This is the biggest question around earnouts. You sit back and you have an offer on the table, and you start thinking about it, and you realize, "What am I going to have to do after this transaction closes?"

You start thinking about it in terms of entrepreneurial risk, and you realize, "Oh my goodness. I'm still going to have to be an entrepreneur to hit all these targets, and I'm only going to keep some of the money." I'm not really de-risking this situation all that much. That's what an acquisition should do. It should de-risk your situation. If the earnout is such that you're still carrying most of the entrepreneurial risk, this is a bad deal for you, and you shouldn't do it, unless there's some other massive reason, like you just want to be a part of a bigger company or something. You probably shouldn't do it. That's the fourth question you've got to ask yourself, "Will it allow me to de-risk my ownership of this firm?"

Blair: I imagine you've been in some engagements where you're representing the firm being acquired, and the principal of the firm looks at the terms of the earnout and goes, "What's the point? Nothing changes for the next three years in terms of the risk I'm taking, the work that I have to do, other than a small amount in my pocket." Then that owner decides not to sell. Is that fairly common or not uncommon?

David: It's not uncommon. It's called a crossover analysis, where you say, "If I just keep this firm without selling it, how long do I need to own it before I get as much money as I'm projecting to get in the sale of the firm?" If you have to keep it longer than, say, two and a half, three years or so, usually it's better to sell it. Usually, in that crossover analysis you're doing, you just assume you're going to walk away from the firm, which you're not really going to do. You're still going to do something else with it.

If you're going to have a boss, your life better be very different, and it better be de-risked. If it's not de-risking your situation, the truth is you're unemployable. I'm unemployable. Most of the people listening to this are unemployable. They can hold their breath for two or three years and be employable, but it's a different game for them. They exchange a boss for de-risking their situation, and that's what you're thinking about when you're looking at an earnout.

Blair: I think three years might be pushing it, but 18 to 24 months, I think we could all hold our breaths.

David: You can hold your breath that long. [chuckles]

Blair: All right, David, this has been really informative. Thank you.

David: Thank you.