I must state that I’m not a big fan of earn-outs. In my eyes, they are very problematic for the seller and buyer.
In most scenarios, selling the company means handing over control to the buyer. Even if in the new setup the founders are still in a management position, they are not the owners anymore and, therefore, cannot decide things in the same manner as they were in the past. If you have the rare situation of your company still operating in exactly the same way as the past, and your decision power is almost unchanged, as the new shareholders want you to continue with the business in exactly the same way then this might be different. However, for all other scenarios you typically see one or more of the following patterns:
- Selling your company is a process which has a lot of time pressure and a high work load, on both sides. Most likely, you will not speak with your buyer about the future of the joint business for a long time as there dozens of topics to discuss. More than that, you’ll very often have the situation that you will speak with other people during the selling process and then, afterwards, to the ones who really decide about the day-to-day operations. Therefore, you can safely assume that whatever you discuss in the selling process will not provide you with the full picture. From both sides, you will learn a lot in the months after the contracts are signed. Some of these learnings will, for sure, be different to the assumptions you had when making a forecast for the next few years. If everything is better than what you assumed then you are lucky but most of the time things are more difficult than they seem during the selling process. Then you are suddenly confronted with an earn-out target which is much harder to reach in this new setup than you assumed.
- The buyer typically assigns members of his existing management team to run the acquired business. In many cases, one of these managers is your new boss. For them, it might be a very important career opportunity and they have to prove themselves. The last thing they want is to have to listen to you every day how they should run “their” business. They wants to run it according to their believes and this is often very different to how you did it in the past. This puts you in the position to veto everything which you believe the new management does that could harm the parameters on which your earn-out is based on. For legal reasons, you might even be forced to write formal letters vetoing against such decisions. A constant fight between you and the new management is very often the result of this.
- Before you sold the business, you where the boss and decided everything alone. Many things will have been decided based on your gut feeling. You were fast, you where lean, and you were successful with that. In the past, you did not make everything into a PowerPoint presentation explaining why you have decided A and not B. Sometimes, you even find yourself in the position where you know that A is the right direction but you do not have a water-tight argument for it. You simply “know” it. This often ends up in either a fight between you and the new decision makers or in frustration on both ends because they simply do not share the same gut feeling.
- If your buyer is large then there is a higher chance that you should expect a lot of rules, policies, and politics after the acquisition. Managers who have worked for many years, primarily for large establishments, are used for such behaviour but typically founders act in a very lean way and hate this kind of bureaucracy and politics. If you are one of these types of people, you should be very cautious signing a contract where the earn-out binds you to a situation for many years where you have to stay in an environment which is not made for you.
To summarise, earn-outs are a possible solution to bridge the gap between sellers and buyers if they cannot agree on a final valuation. However, I think it is very critical for the seller and the buyer if the earn-out is more than the icing on the cake for the seller. In any case, the earn-out period should be short and the decision power, during this earn-out period, has to be carefully discussed.