The Perils of Earn-Outs

It’s quite common in mergers & acquisitions for deals to get structured such that some of the price gets paid on closing, but some is reserved to be paid out IF the target (company being bought) hits certain performance targets.

This is an ‘earn-out’ clause. You earn this additional money if you hit agreed-upon objectives.

While this sounds perfectly rational, I always caution sellers to avoid earn outs whenever possible.

At the end of the day an earn-out is really just a disagreement over the price. You think your company is worth $100M. The buyer thinks it’s worth $75M. You have no leverage because you’re dealing with one buyer. So, you agree to a $ 75M deal with the possibility to earn more based on your performance.

The issue with this is that as soon as you have sold your company, you’re no longer in the driver’s seat. As a result, you are likely not in control of all the factors that would enable you to achieve those targets.

What if the buyer cuts your budget so you can’t hire enough people or invest enough in marketing and other programs? What if the buyer just diverts resources to other parts of the company? You have no control over any of this and you have no leverage once the deal has been agreed to.

So, what to do…

In an ideal World, you don’t agree to any kind of earn-out. You run a competitive sale process so that you are dealing with multiple qualified buyers at the same time. You use that competition to drive clean terms including fixed purchase price.

If you end up in a scenario where you decide to do an earn-out, then I have two things to say: i.) Spend a lot of time discussing HOW you will achieve those targets. Try to provide in writing for the resources needed to achieve them. Give yourself wiggle room so that things don’t have to go perfectly; and ii.) Do the deal assuming you won’t get the earn-out. If you do, it’s gravy.