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Friday’s Exit Strategy: Negotiating Earnout Terms

You’re gearing up to sell your business. Or perhaps you’ve received a buyout offer. At some point in the process, you’ll likely need to consider earnout terms.

Sure, you’ll receive a portion of the sale price up-front. But there’s also a chance that you’ll receive a portion of the sale price over a set time period — perhaps a year or two — based on you hitting key revenue and/or profit targets over that time period.

Earnouts can benefit both the buyer and seller. They also come with risks — mostly for the seller, but also for the buyer in some scenarios. Think of an earnout using this hypothetical scenario:

  • You want to sell your business for $5 million — cash, upfront.
  • A buyer is only willing to pay $3 million cash up front. The buyer is particularly worried about the business tanking post-acquisition, and unwilling to take on more risk than that $3 million commitment.
  • To bridge the gap for both the buyer and seller, the buyer agrees to  pay $3 million up front, and another $1 million over a two-year period — $500,000 one year after the sale, and another $500,000 two years after the sale. That’s still $1 million short of the seller’s original ask, but perhaps tempting enough to trigger a deal. The catch: The seller has to hit certain profit or revenue milestones to score each portion of the earnout.

Earnouts: What They Should Include

The approach often looks good on paper. But the seller has to keep at least four major variables in mind, according to Inc. They include:

  1. Keep your key players. If other executives were integral to your company’s growth and success, will your company be able to function under new ownership without them? If not, come up with deals to lock them in, too, Inc. notes.
  2. Keep the length of your contract as short as possible. It sounds obvious, but you’ll minimize the potential for burn-out by minimizing your time working with your new parent company. You can always renew and re-negotiate, but can’t hit undo, Inc. says. A short earnout window is typically a year.
  3. Make sure you have control. Ensure that the contract expressly states that you will oversee any departments that will be executing on the goals and standards set forth in the earnout, Inc. says. You should never allow yourself to be accountable for what you cannot control, the site recommends.
  4. Ensure that incentives are in placeYou know what motivates you at work. One is seeing your business succeed, and the second is money.  If you’ve made a lot of cash in the initial sale, it’s natural to loose attachment to future goals for the company. The earnout percentage should be high enough to keep you from losing interest, especially in the event of a setback, Inc. says.

Earnouts: Additional Considerations

I’ve lived through an earnout, and I’ve also spoken with plenty of MSP buyers and sellers about their earnout experiences. Without pointing to any one particular buyer or seller’s deal, here are some aggregated thoughts about how to navigate an earnout.

  1. Know your numbers: As the seller, you need to truly believe you can hit the financial or business metrics contained in your earnout. During the sale process, negotiate toward achievable goals — not pie-in-the-sky figures.
  2. Don’t be afraid to say no: Once the sale becomes official, the buyer may start asking you to focus on new projects or shiny objects. Don’t be afraid to say “no thank you” if those new efforts don’t align with your earnout objectives.
  3. Negotiate upward: What if your business performance easily exceeds your earning objectives. Is there additional upside for you? Don’t be afraid to broach that subject during the M&A discussions. But do so in a reserved manner. Say too much, and the buyer may sense that the initial earnout targets are far too easy to meet…
  4. After the earnout: What happens to you and your position after the earnout window is completed? Know your long-term compensation and career goals during the M&A process and during the earnout stage. Don’t be afraid to negotiate your salary and compensation upward after the earnout is complete — especially if you know you have a high value to the ongoing business. But always have a backup plan in place. If you don’t get what you want — what’s your post-earnout plan B?
  5. Maintain Strength in Numbers: Yes, I’ve lived through an earnout. And it all went well. But that’s because I was a wingman to a great pilot — my business partner, Amy Katz. If your business has multiple owners ahead of the sale, make sure each owner is 100 percent aligned with the earnout. And make sure one person oversees how those earnout metrics are met.

If you’ve lived through an earnout and want to share experiences, I’m all ears (Joe@AfterNines.com).


Joe Panettieri (@JoePanettieri) is co-founder and executive VP of After Nines Inc. and its IT media platforms — ChannelE2E and MSSP Alert.

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2 Comments

Comments

    Gary Pica:

    I have also lived through an earn out. Be sure that you have control over the key drivers that impact the earnout goal. In other words if there is going to be an integration process, be sure you are comfortable the process.

      Joe Panettieri:

      Hey Gary: Great point. It brings up the classic “Do no harm…” debate, where the buyer essentially doesn’t make any major changes to the seller’s business for about a year (+/-). That can be great for the seller’s near-term focus on earnout goals. But it also comes with some longer-term risk for the seller — as pointed out here….
      -jp

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