When the late US entrepreneur Tony Hsieh sold LinkExchange, the advertising venture he’d co-founded in 1996, to Microsoft less than three years later, he received $40m (£24m) immediately. He was due to earn a further $8m from the deal if he stayed with the business for 12 more months.
In his 2010 autobiography, Delivering Happiness, Hsieh used the pun “vest in peace” to describe the boredom that led him to walk away from LinkExchange before the year was up. That phrase has since become a Silicon Valley cliché. It refers to what happens when an entrepreneur sells their business and receives a tranche of share options that mature (vest) in a year or two, under an arrangement known as an earn-out. Until that final pay-off, they loaf around, offering little value to the business they worked hard to build. The implication is that earn-outs are ineffective incentives.
“I wasn’t going to sit around letting my life and the world pass me by,” Hsieh wrote. “People thought I was crazy for giving up all that money. And, yes, making that decision was scary, but in a good way.”
Earn-outs are supposed to render acquisitions more attractive to both parties. Sellers can close deals that may not otherwise happen and acquirers can reduce their initial costs while incentivising the founders to ensure that the business continues to prosper after the sale. Yet many sellers feel that such arrangements, especially those that impose unrealistic performance targets as a condition of further rewards, are biased against them.
Earn-outs rarely work out well for sellers. Many corporate financiers will advise them to obtain some more unconditional money instead
William Pinnock, head of the corporate and commercial team at Glaisyer Solicitors, agrees that “earn-outs rarely work out well for sellers. Many corporate financiers recognise this and will advise their selling clients to sacrifice at least some of a potential earn-out sum to obtain some more unconditional money instead.”
So how can earn-outs be structured to be more equitable and effective? For one thing, both parties need to be sure about what they’re agreeing to at the outset. So says Stephen Page, founder and CEO of SFC Capital (formerly known as the Startup Funding Club), who observes that many such agreements are not specific enough.
“Pitfalls are all in the language of the deal,” he notes. “There can be grey areas within the terms.” (See panel, opposite page.)
Dan Coppel, a London-based corporate partner at global law firm Morrison & Foerster, agrees. He argues that earn-outs should offer sellers greater protection against risks that will be beyond their control.
“What if the buyer doesn’t allocate the resources necessary for the seller to hit their targets? Or what if it restructures the business, making it problematic to track performance? Failure to account for such factors in a deal means that sellers can be short-changed through no fault of their own,” he says.
Karen Thomas-Bland, the founder and director of Intelligent Transformation Partners, has worked as an adviser on about 50 M&As. She believes that sellers need to be granted a meaningful say in how the business is run even after they’ve parted with most of their equity.
“They need to keep operational control during the earn-out period, while performance metrics need to be unambiguous and easier to track than, for example, net income or Ebitda,” Thomas-Bland argues.
She also recommends that pay-out terms be made more flexible, enabling sellers to be rewarded on a sliding scale according to their achievements. This is fairer than a so-called cliff-edge arrangement, under which they would receive either the full amount or nothing, depending on whether they hit all their targets or not.
Structuring earn-outs as a clear win-win situation is the method favoured by Peter Blanc, one of the UK’s most prolific acquirers. So far this year he’s overseen 14 M&As for chartered insurance broker Aston Lark, where he’s group CEO.
“We’ll complete about 30 deals this year,” predicts Blanc, who explains that the earn-out deals offered by his firm “avoid trigger events, because these can create unwelcome behaviour. For instance, we wouldn’t want to create a situation where a vendor knows that they would receive a large pay-out if they were to sell another £100,000-worth of insurance. That would lead to bad client outcomes.”
He continues: “Our thinking is simple: we offer them a multiple of whatever proceeds are earned over the two or three years they’re tied in. That’s a sensible reward – and it means that we don’t have that horrible cliff edge where they would risk losing a big sum.”
This approach means that sellers receive a decent price for their company and are also motivated to make the business more profitable, knowing that they’ll benefit fairly from such an outcome.
“We never put in any clawback provisions. It’s all carrot; no stick,” says Blanc, who adds that having an honest conversation with the seller ensures that both parties are clear about what they want from the deal. “If a vendor wants to go to Monaco and be a playboy, say, that’s fine – as long as he leaves a management team behind to run the business.”
Such a candid approach has the added benefit of reducing the likelihood of a culture clash. This is “probably one of the biggest risks in earn-outs”, says Sangeeta Mistry, a specialist in reward at M&A integration consultancy Global PMI Partners.
“Typically, founders who may not be suited to corporate life will leave the acquired company as soon as their earn-out period ends,” she explains. This can result in a mass exodus if the acquirer is retaining several sellers who are due for pay-outs at the same time – a significant problem if it hasn’t done the requisite succession planning.
“We’ve also seen situations where founders are protective of their staff while still in position. This makes it harder for the buyer to plan any restructuring,” Mistry adds.
Ultimately, earn-outs need to work for both parties in practice as well as in theory. Otherwise, like Tony Hsieh, the person who built the business will walk away – even if millions are on the table – rendering the whole exercise pointless.
Common earn-out mistakes
Here are some of the most inadvisable practices that buyers and sellers often engage in.
Involving the lawyers on day one
An acquisition is a meeting of minds, especially when all the founders and their entire management team are being retained. A deal requires goodwill and understanding between the parties. The moment that legal documents are drafted, the mood changes, so don’t call on the lawyers until you’ve built a strong enough rapport.
Relying on a template
Every deal is different. An earn-out will require agreement on the right measures. Turnover and Ebitda are common starting points, but other metrics can include client retention, revenue per customer and cost savings achieved through ‘synergies’. Non-financial metrics – regulatory approvals for new medicines in the pharma sector, for instance – can prove useful too.
Going to the cliff edge
This is a deal that’s structured so that the seller receives all or nothing, depending on whether they hit an absolute target or not. Such deals encourage ‘malicious compliance’: the pursuit of targets despite the harm this may cause the business – for instance, offering loss-making discounts to attract a set number of new customers.
Failing to provide adequately for force majeure
An earn-out can be affected by political, social and even geological events beyond the control of any party that will nullify its reward structure. The arrangement should account for the unexpected in advance. Defining force majeure is notoriously tricky – this is one area where the lawyers really earn their fees.
