Beware the earnout pitfalls
Robert Maxwell, the disgraced business tycoon, had an interesting technique for acquiring businesses. He’d establish the likely cost, then offer the owner three times as much. He’d put down 10%, promising the balance to be paid over two or three years against a formula based on some measure of future business performance – the so-called “earnout”.
Having won the deal, his lawyers would leave no stone unturned to avoid paying a penny more, making post-acquisition life intolerable through fair means or foul, and forcing the departure of the poor unfortunate(s) who would never see more than the 10% cash figure.
This is lesson number one for anyone being offered an earnout deal. Do not take for granted that you will see anything more after the cash at completion.
That is not to say that earnouts should be dismissed out of hand. For growing businesses which are still dependent on the owners making things happen, or without a significant track record, they often represent the only way for the owners to achieve their hoped-for value. However, most never quite work as the vendor would like.
Before agreeing to any earnout you need to be absolutely clear that the target is achievable and cannot be changed or manipulated by creative accounting or the sudden post-transaction appearance of corporate management fees to move profit to the acquirer.
How do you measure the post-acquisition performance, and over what period? Should it be sales, gross margin or operating profit? For how long? How is each of these going to be influenced under the new regime? Will an acquirer leave an acquisition as a stand-alone?
We agreed one such deal recently where the business was ring-fenced for a year with no external management interference. Circumstances permitted it, but this is rare. It just about worked okay but most acquirers want to see overhead savings, the merging of distribution channels, or new product development “rationalised” as soon as possible in order to pay for the acquisition.
These might ostensibly be beneficial to your bottom line but can have an unsettling short-term effect on the stability of staff and resources. For example, you may make good margins because you pay your suppliers promptly in 30 days and they give you good service. Group settlement policy might become 60 days, and your suppliers become less supportive with a knock-on effect on your business.
Or what happens when your best salesman is sent off on a residential management course for a week to learn about the group’s other products? Neither of these scenarios may be intended to stop you achieving your targets, but both could do so. The challenge for you and your advisers is to create a formula, with extensive conditions, that cannot be breached, even if lawyers will never guarantee that it can be made fully waterproof.
Once you are in to the earnout period itself, those targets can start to seem daunting, especially if there is early slippage. Previous minor delays in closing a significant new contract didn’t matter too much. But what if that slippage affects the profit for the defined period/earnout? How do you catch up? Can you? After month three, you and your fellow shareholders will have a gnawing realisation that, whatever you do, you’ll be kissing goodbye to that second big payday.
Not only that, all eyes will be turning to the bullish sales projections prepared by the sales director which formed the basis of the earnout target. His popularity rating starts slipping rapidly, not helped by the rest of the team pointing out that if the final results are £1 short of the agreed target, the entire earnout will be lost… and it’s all down to him!
Other strange things can happen. We agreed one earnout last year based around a sales performance for the subsequent 24 months. The company had one substantial international customer. Six months after the deal the acquirer sold itself to a global business which was a direct competitor of that international customer.
At a stroke the prospects of achieving the earnout disappeared. We were able to negotiate a reasonable walk-away figure, but any litigation would have had to prove that the sale to the global business was a deliberate attempt to avoid paying the earnout.
Finally, however reassuring your new chairman seems (“nothing to worry about, old boy”), never accept that all will be okay. Not because he is deliberately misleading you, but simply because he might not be there in a year’s time when the debate on payment reopens, and his successor turns out to be Mr Maxwell Mark II.
Earnouts can and do work. However, proceed with care, ensure your advisers understand the pitfalls and assume that the cash at completion is all you’ll ever see.