The Tricky Business of Earn-Outs

It’s been an exciting ride. You started off with a great idea, navigated the pitfalls of growth and turned the fledgling company into a viable business. Just as you speak to one of your major partners, a question comes up: Would you be interested in selling the business? You are excited, this is the moment you (may) have been working for. You are waiting for the other side to mention a number and there it is! It is better than you expected but there is a catch. An earn-out. You will only get a small cash-out up front followed by further payments over the years as your business hits performance targets. This sounds like a reasonable idea. The valuation appears attractive. You are confident in your business and have nothing to hide. Maybe the thought of a few years in a larger corporation appeals to you.

Unfortunately, the reality is not so easy and founders end up with a fraction of the transaction value in their pocket and a bitter taste in their mouth. Here are a few reasons that we have come across.

1. Adrenaline drop

Let’s face it, the excitement is not quite the same when the business is no longer yours. You find yourself back in the kind of environment that you wanted to escape in the first place. It is not unusual for Founders to become restless in their new environment. Minimum attention and effort is put into the new role. The ball is dropped and the targets are missed. This is hugely disappointing and frustrating for all involved.

2. Divergent Management Styles

Similar to the point mentioned before, fitting into the new leadership means a loss of control for the Founder. Often it was this authority that made the business extra agile and helped it win customers. With the new owners, decision-making is slower and generally more risk-averse. The acquired business is missing its targets. The buyer is unhappy because the deal does not look so accretive anymore. The founder is arguably in the worst position. S/he can see their business fall behind but feels hobbled in an effort to drive growth.

3. Unrealistic Performance Expectations

Earn-outs are typically structured based on the company's future financial performance. While this approach may seem logical, it often leads to unrealistic expectations. Founders may have an optimistic outlook on the company's potential, while investors may have a more conservative view. When the actual performance falls short of lofty targets, tension arises, and blame can be directed at founders, eroding trust and damaging relationships.

4. Bad Faith

This list would not be complete (and indeed it isn’t) without this unsavoury point. There is a strong incentive for the buyer to make it appear as if the acquired company is missing its targets. In some cases when the acquirer’s and the target’s businesses are overlapping, the new owners may just shut down this former competitor. More common and less dramatic is redirecting revenue streams, withholding investment and reassigning key staff to new roles. Revenues which the seller believes belong to the target company are attributed to another company within the buyer’s group or costs which the seller considers should be charged to the buyer’s group have been put through the target company. This is infuriating for the Founder who loses the value of his/her business to the new owners.

This list is far from complete and Founders as well as Angels have their own story to tell about an earn-out gone awry. Having said all that, earn-outs are a central element of most exits. Founders and their investors should realise that the full transaction value is at significant risk. A smaller and shorter earn-out element at a lower valuation can often produce higher returns for the Founders and their investors.

As a founder, what discount would you accept to avoid a year of earn-out?

• None!
• 10%
• 20%
• >20%