MONEY (& the trouble with earn-outs)
I really dislike earn-outs. I’ve seen some doozies in the last few years.
Earn-outs are one of the most commonly used tools in M&A. However my experience is they don’t always work, and there are major pitfalls.
A bit of context: for the past five years we’ve been putting together a technology and services business so this piece needs to be read in the context of people-intensive businesses.
Conceptually an earn-out can close the valuation gap between a buyer’s budget and a seller’s dream. A seller can see upside beyond the negotiated sale price, and a buyer can gain comfort that the price being paid is justifiable. Fine on paper.
In real life it can suck. Let me play out three scenarios:
Vendor A: the seller who wants to stick around
Vendor A wants to go for the journey. He or she wants to be part of a bigger business and will typically see upside not just from the initial sale but from a subsequent incentive plan that heaps reward on reward for success.
Vendor A will want to maximise the value of the business sold and build something much larger. Overheads will be kept tight while revenues are built. Staff will be invested in albeit at a pace that maximises earnings. When the earn-out is complete earnings don’t fall, they rise, and rise.
Vendor A is the sort of person you want to deal with. Hold them tight.
Vendor B: the seller who has no intention of sticking around
Vendor B professes undying love for the business and purports to want to stay for a considerable period post earn-out. However Vendor B really just wants to cash in and go the minute the ink is dry on the post earn-out audit. You’ll never know Vendor B’s intentions until after the last payment is received because Vendor B doesn’t want to upset the buyer of his business.
You buy 100% of the business. Vendor B keeps you at arm’s length on grounds that “I have an earn-out, and even though you own the business if you interfere with the management of the business it will affect my earn-out and therefore you cannot get full management control.”
Vendor B subtly decreases costs. Departing staff are not replaced. Discretionary spend is curbed. Under-investment becomes the norm – the sort of under-investment that you won’t see hit the P&L in 12 months but you probably will in 24-36 months.
Vendor B also takes a mercenary stance with clients, taking every little opportunity to charge more. Again subtle, but can cause issues with client relationships that don’t appear until the end of the earn-out.
Vendor B’s employees feel that they are being under-invested in and that the new owner doesn’t care. The new owner does actually care, but is kept at arm’s length by Vendor B.
The result is suppressed overheads, mildly inflated revenues and unloved employees. The business probably has little management foundation behind Vendor B with all the attendant risks when Vendor B departs.
Most importantly, you cannot integrate the business with yours. You may be able to in name, but that’s all. You won’t be able to build a culture or build any of the basic human chemistry that you need in place to welcome the business and its clients into your network.
The earn-out does however prove to be a nice little earner for vendor B, who is now the guy on the third deck chair away from the pool bar with the little umbrellas in his cocktail. Meanwhile profits fall considerably in the following year and having paid for Vendor B’s extended holiday, you have a problem.
Sometimes (…most of the time!) it’s hard to work out whether you are dealing with a Vendor A or a Vendor B. I’ve found over the years that sitting down pre and post deal and having a frank and honest chat is the best way to work out what’s going on.
There are many perfectly decent vendors – let’s call them Vendor C – who are ready to sell and move on. We can’t blame them for wanting to make money and leave – I’ve sold companies and done it myself. The trick is to identify their objectives and reach an agreement on what is going to happen in future before money changes hands.
As acquirer you may create a genuine sense of relief by making it clear that that there’s no shame in Vendor C wanting to maximise the value of his business and leave. You just need to agree a framework for finding a suitable replacement, and making sure the successor is good, before you make the final payment.
Case Studies in Failure
You simply can’t create a culture or build a business if you assemble a group of companies with each on its own earn-out. Each participant with an earn-out will march to the beat of its own drum with little regard for the economics, objectives or culture of the new owner.
About five years ago we were offered a controlling position in a public company – a failed roll up – that had bought a large number of marketing services businesses. The parent company had been founded on the flawed premise that you could acquire a group of similar businesses under a single umbrella, buy them, retain the owners and keep earnings momentum through earn-outs, as well as encourage everyone to share their clients and cross-sell to each other. A number of publicly listed companies did this just prior to the financial crisis – and many failed.
During due diligence we assembled all the business heads around a table to discuss the deal and assess the chemistry. Almost all of them had their arms crossed, defending their businesses, defending their clients, and were hostile to co-operation. “I have an earn-out” was the theme,” if I share my clients with you, and you perform poorly, my earn-out will suffer. So I’m not sharing anything.”
That’s where we learned about Vendor B and how he operates.
My advice is simple – earn outs are problematic in service industries. The scars on my back prove it. If you are buying such a business and see any impediments to building a culture, run a mile. If there are impediments to working together, run a mile. If you think your vendor wants to sell and run, you should run (unless you have a better replacement).
There are a few structural alternatives mooted – partial sales with puts and calls, and so on. These are all devices for dealing with the same issue – make sure you are closely aligned with management and that they see a future in your business, not just dollar bills.
In the end it boils down to people. Get inside your vendor’s head before you spend a dollar on due diligence or buying a business. That’s the starting point, and it’s probably the end point.