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Performance related pay: are earn-outs the best way to maximize value?

Posted by BIMA knowledge-sharing Legal & Finance May 29, 2013
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If you are an entrepreneur thinking of selling your digital media business, there is a strong likelihood that a buyer will want to tie part of the deal value to the performance of the business after the sale. This is known as an “earn-out”. Earn outs can be beneficial to both the buyer and seller, but this is not always the case…

When are earn-outs used?

Earn outs are particularly common in the digital media industry where the value of the business is its future growth or where the success of a business is often down to the drive and talent of the entrepreneur behind it. Keeping that entrepreneur on board after the business has been sold for a period of time (typically two to five years) is often attractive to a buyer. It can be attractive to a selling entrepreneur too, if he or she is properly incentivised.

Put simply, the better the business performs post-deal, the greater the return on the buyer’s equity and the greater the earn-out payment for the seller.

Theory vs practice

However, the reality of earn-outs often doesn’t match the theory.

A fundamental objection to earn-outs is that they often require the seller to act like an employee rather than an entrepreneur after the sale. The business may have looked attractive to the buyer because it was being run by an autonomous creative visionary.  If you take that entrepreneur and squeeze him or her into a corporate role where he or she has to report to a board, arguably the very thing that made the business successful is being taken away.

Similarly, is the entrepreneur going to be satisfied with this newly-constituted role?  He or she became successful by being dynamic and taking risks – if the new role doesn’t allow for this, the earn-out targets become that much harder to achieve.  Also, the existence of the earn-out can mean that a seller becomes preoccupied with it rather than broader business issues. The inevitable result is a less profitable business. This benefits no one.

A more prosaic concern with earn-outs is that the relevant provisions contained in the definitive transaction documents are usually complex and very difficult to administer in practice. Questions such as how the post and pre-acquisition performance of the target business should be measured are not always easily answered. There are other complicating factors at play: the selling entrepreneur will want comfort that the buyer won’t do anything deliberate to reduce the value of the earn-out while the buyer will want to be able to pull the plug on the-earn out if the selling entrepreneur does anything particularly egregious. All this can result in lengthy negotiations, some pretty heavy-going legal drafting and, in a worst case scenario, a dispute down the line.

What can an entrepreneur do?

Whilst a buyer may use “we’re all in it together” style reasoning to justify an earn-out, the fact is that an earn-out can often simply be a hedge which protects the buyer against a post-acquisition performance drop-off. Put simply, an earn-out is often in the buyer’s interest whereas most entrepreneurs would no doubt prefer the cash up front. Unfortunately for selling entrepreneurs, the balance of power will usually be with the buyer.

So, if an earn-out mechanism is demanded by a buyer, what can the selling entrepreneur do?

•    Keep financial metrics simple and fully understand how the buyer intends to integrate the business.

•    Anticipate likely scenarios which could endanger future earn-out payments – what happens if the buyer on-sells the business or under-resources its operations?

•    Keep the earn-out period as short as possible.

•    Include early payment triggers or tie earn-out payments to business milestones.

•    Include contractual protections for the entrepreneur – the buyer should be prevented from deliberately frustrating the earn-out.

•    Insist that target business remains structurally autonomous during earn-out period or at least that the selling entrepreneur has a say in decisions of the business which could affect the earn-out metrics.

•    Do not tie payout to continued employment with the business.

Would you consider selling your business if you were tied into an earn-out? Let us know what you think…

About the author: Julian Grant, Associate at Kemp Little LLP, leading technology and digital media law firm. Julian can be contacted on julian.grant@kemplittle.com

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