How to Survive an Earn-Out

22 Jul ’05

Anthony Cerminaro links to a Business Week.com article on using earn-outs in M&A transactions. Highlights:

Before you agree to anything, get a lawyer who specializes in mergers and acquisitions. Besides helping to negotiate the deal, a lawyer can keep emotions from boiling over when things get dicey. “If you feel uncomfortable taking a hard line with a buyer, who may also be your future employer, your attorney can be the bad guy,” says Mark Mihanovic, a partner with Los Angeles law firm McDermott Will & Emery. “You can stand back and be above the fray.”

The next step is obvious: Get the largest up-front payment you can, even if the earnout is substantial. When Christi Black and her partner, Robert Deen, sold their eponymous Sacramento public-relations firm in 2001, they negotiated an immediate payment of $2 million. Even though the lion’s share of Black & Deen’s value was contained in the four-year earnout, the duo reasoned that $2 million gave them the cushion they needed. Says Deen: “Even if we tanked, there was some protection.”

Then, you’ve got to negotiate the targets for the earnout — usually revenue or profit goals — and make sure you’ve got a reasonable chance of achieving them. But what was reasonable under your leadership may not be under the new owners. So it’s essential to protect yourself in case they decide to operate differently, as happened to Feldman and his partners. “If the buyer makes significant changes to processes and operations, make sure it doesn’t affect your compensation at the end of the earnout,” says Minor.

That means that if your earnout is based on profit numbers, you need to make sure the buyer can’t use excessive spending to depress earnings. Your agreement should include budgets for capital expenditures, research and development, advertising, and maintenance. Or you can stipulate that the income calculation won’t include overhead costs. That way the purchase of a new computer system, for instance, won’t hurt your chances of making your earnout.

Lots more in the article.

There are many other factors to consider, of course, but one in particular is worth mentioning: take care to ensure that the agreement addresses what ought to happen to the earn-out obligation if the purchaser re-sells the business, or part(s) of it. Awkward problems can arise if the business is resold within the earn-out time horizon and the agreement is silent on the issue.

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