Key Considerations in Negotiating Earnouts when Selling a Company

March 6th, 2010

Last week the WSJ ran an article saying that Google is moving away from earnouts when it acquires companies.  Earnouts are a tricky thing whether you are a buyer or seller in an M&A deal.  The article gives a glimpse into some of the issues.  Here is a rundown on some of the background considerations.

Definition of an Earnout
An earnout means that if you are a key employee in a company being acquired, some of the total purchase price in the deal gets paid to you over time based on your continued work on the product post-acquisition.  The premise is that some people are passive shareholders who put in cash and don’t have a key role going forward, so they just get paid out at closing.  On the other hand, some team members may be necessary after closing to keep development moving on the product, so their compensation in the deal is linked to continued success of the selling company’s product post-closing.

Keeping the Product Going
Implicit in this formula is the idea that the buyer will keep the seller’s product alive post-closing so that both sides can measure success and the sellers have confidence in their ability to achieve the earnout.  The WSJ gives Disney’s purchase of Club Penguin as an example of this- Disney bought Club Penguin and has kept it as an independent product.  This makes it easy(ier) to measure Club Penguin’s future results and calculate whether earnout metrics have been met.

Compare this with Google’s acquisition of Grand Central.  The product essentially went dark for about two years and then re-emerged as the largely free Google Voice.  I don’t know if the Grand Central acquisition involved an earnout.  If it did, it would certainly be much more difficult to work out success metrics than in the Club Penguin situation.  Google buys a lot of companies for the teams or for product sets that can be worked into larger Google suites, so I can see why they would have trouble measuring earnouts.

Key Considerations
When an earnout is involved in a deal there are several important factors that buyers and sellers need to consider.

-The first is the most objective metrics the deal will permit.  Product revenue is ideal.  It is a pretty easy number to track and works well if the product will be independent post-closing.  If the product will be rolled into a suite of buyer’s products post-closing, or if the seller’s product is free then this metric doesn’t work as well.  On top of that, even if revenue is the main goal we need to think about what would happen if the buyer decides to close down the product line.  Would the earnout accelerate in that situation? Partially accelerate?

-Second is freedom to manage the business.  This usually comes down to “best efforts” language so that the seller has something in writing to say the buyer will put enough resources behind the product to allow the earnout to be met.  It is very hard to make an ironclad promise out of this, since the buyer usually wants freedom to change its business plans and goals as the market requires.

-The third factor is flexibility.  It is impossible to predict what will happen to a product or business, so an ideal earnout will provide enough wiggle room so that if the buyer’s business plans change, the seller can still claim right to payment of some or all of the earnout.

-The last factor is trust.  When a big part of the deal hinges on future performance, buyer and seller both need to have faith that everyone will behave going forward.  The buyer wants to know that the seller personnel won’t make decisions that guarantee their earnout at the expense of the larger business, and the seller needs to believe that the buyer will keep the product alive and manage it in a way that lets the seller achieve the earnout.

Earnouts are usually the most contentious part of M&A deals.  We always do our best to understand the other side’s needs and objectives in the deal, but there is inevitably a leap of faith on both sides that the deal will work out to everyone’s benefit.

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  • patricklynch

    Great post. One additional consideration I would throw out: be aware of sensitivities the buyer may have to the impact of earn-out structure on reporting the transaction in its financial statements (particularly if the buyer is public). Changes in accounting rules within the last couple years has altered the connection between earn-out consideration and earnings accretion / dilution. Granted, a change in accounting rules certainly doesn't change transaction economics, but it can change perception of a transaction (and thus behavior).

  • http://blog.jparkhill.com Jay Parkhill

    Good point. That may have something to do with Google's “trend” as well.

  • patricklynch

    Great post. One additional consideration I would throw out: be aware of sensitivities the buyer may have to the impact of earn-out structure on reporting the transaction in its financial statements (particularly if the buyer is public). Changes in accounting rules within the last couple years has altered the connection between earn-out consideration and earnings accretion / dilution. Granted, a change in accounting rules certainly doesn't change transaction economics, but it can change perception of a transaction (and thus behavior).

  • http://blog.jparkhill.com Jay Parkhill

    Good point. That may have something to do with Google's “trend” as well.