I didn't play much basketball as a kid. Only a couple of seasons. Soccer was more my thing. But I distinctly remember one fifth grade basketball team. One of the other kids on my team was a pretty good player. We'll call him Blake. Blake could bring the ball up the court and he could shoot. But he would never pass the rock. It seemed as if Blake was trying to win every game on his own. A few games into the season, Blake shared a tidbit that explained things. It turns out that Blake's Dad had told him that he would earn fifty cents for every bucket he scored. With that kind of incentive structure in place, Blake had no reason to pass the ball and every reason to take as many shots as he could. There was no rationale to integrate the rest of the team into his game plan.
When one company acquires another - especially a smaller, closely held entity - the acquisition price often includes an earnout component where part of the purchase price is held back for some period and payment is dependent on a measure of post-transaction performance. All of this seems very logical at the time of the transaction. The expected benefits of an earnout structure are readily evident.
- Earnouts allow the buyer to "fund" the acquisition transaction with future operating cash flows
- They allow the buyer to mitigate the risk of overpaying for a business that declines in performance post-transaction
- They incentivize the seller(s) to stay focused on business performance and "lock them up" for some period of time
But, just like Blake's 5th grade basketball incentive, earnouts can inadvertently become the ultimate tool in preventing post-transaction integration.
If you are on the acquisition path and contemplating an earnout structure as part of the purchase price, here are a few predictions, based on our experience in over 100 mergers and acquisitions:
- There will be arguments over the accounting. This is especially true when earnouts are based on earnings measures like EBITDA. Why? Calculating things like overhead allocations once the acquisition is part of the new organization can feel like more art than science. And as we like to say, the number of overhead allocation conversations you are having at the end of an accounting period is almost always inversely proportional to the level of customer service you are delivering.
- The acquired company will fight to preserve their "independence," wanting to keep the resources they need to support their earnout goals close at hand.
- Revenue synergies will be hard to come by, if part of the value proposition for the acquisition included an expectation that the acquired firm sell your products into their customer base. The acquired firm's folks will focus their energies on their own legacy products which support the earnout calculations.
- If performance falls short, payout time will bring finger pointing and heated discussions about who is to blame and whether or not the earnout should be paid anyway. This finger pointing has escalated into the courtroom more than a few times.
Overall we'd characterize the impact of an earnout structure as a terrific integration prevention mechanism. The very existence of an earnout creates rationale for an acquired business to stay independent. The previous owners will want to keep control of their own sales organization (rather than centralize it), their own brand, their own customers and their own strategy. Being hyper-focused on achieving the earnout goals means there is no time for distraction from keeping the acquired business humming. That may sound like a good thing. But when the deal value is predicated on synergies like cross-selling the buying company's products into the acquired company's customer base or centralizing sales or marketing or hiring activities, efforts to achieve value are also seen as distractions to the selling company's owners.
Earnouts can have value. From our experience, here are a few keys to successful earnout arrangements:
- Aim to tie earnouts to revenue instead of EBITDA
- Link earnouts to a segment of the acquired business that is complimentary (i.e., not overlapping) with the acquiring company
- Keep earnout periods reasonably short -- i.e., 6 or 9 months is better than 2 or 3 years
- Ensure there is a link between the earnout measures and the value drivers for the deal
In a nut shell, when considering earnouts, leaders and deal makers should be mindful of the pitfalls and proceed with caution to avoid any chilling effects on the post-transaction operations that prevent the creation of a single, integrated team.
You can read more about winning moves for your upcoming merger or acquisition on our blog page here.