Moths Always Find a Flame – The Appeal and Clear Drawbacks of Earnouts

Moths Always Find a Flame – The Appeal and Clear Drawbacks of Earnouts

A gal I once knew said it true: there’s an inverse proportion between quality and popularity.

She was talking about music, the early 1980s variety, when underground reached its apotheosis and popular radio made you feel like you’d been dragged over coral. The worse things got, the better they sold. Lisa and I wondered at the phenomenon, then put on The Stranglers, our private romantic soundtrack to a curious age.

This calls up our topic: earnout provisions in business sales. Nearly 30% of US transactions contain earnout agreements – they’re a smash hit. The idea is simple to express: I’m selling my business, you’re willing to buy, yet we can’t agree on valuation or price. So our contract contains an earnout provision, where I receive additional future payments if defined performance goals are achieved.

These payments form part of the purchase price: if the company does well, the seller wins; if not, the buyer’s protected and paid a fair price. Targets might be gross revenue, the number of new customers onboarded, EBITDA, net income – whatever the parties think reasonable. It all sounds sweet, but such dangers are lurking I’m amazed these deals are so popular.

I call it the tin-ear equivalent in company sales. Why do listeners prefer Olivia Newton-John to Joy Division, or convoluted, manipulable earnout deals to a simple compromise on the purchase price? If you’re determined to try it, at least know the pitfalls. It’s quite a list, but I’ll help you out.

We’ll start with the conclusion: the parties need to hire expert advisors who specialize in company sales and mergers. Savvy, successful managers, perhaps nearing retirement or with a hot-prospect product just set to launch, may think it’s time to sell. Armed with hard-earned wisdom, they think they know everything about their business. What is so tough about a simple contract of sale? ‘We’ll take it in-house’, they think. ‘I’ll handle it personally’.

If you want to sing a song about disaster, try Always The Sun by The Stranglers. That’ll save you the trouble of writing your own.
If you don’t hire a team of specialists who can precisely (read exhaustively) word the contract, get ready for a trip to court. Simple things like the timing and structure of the seller’s payments are maddeningly malleable, hence hard to define. The buyer may offer to pay a portion of net income, a fine measure of overall performance, but for the seller, a bit of gross revenue might better please the palate.

This bedrock is tough to resolve, and it’s just a start. Consider: what happens if the buyer sells the company before your payment period expires? The contract had better include an accelerated payment schedule, and if it doesn’t – well, book a courtroom with rubber-lined walls, because the outcome could drive you that crazy.

When gelling the contract, there are plenty of ways to bridge gaps in perception, and the specialists know how to keep things in balance. Consider the tax issues of earnouts. Are you selling stock or physical assets? Are you aware of the installment sale tax rules, which may apply or not, depending? The business’s structure – LLC, C Corp, sole proprietorship and so on – have complex tax implications. Taxes are always a minefield, breached only by professionals.

I hope we’re seeing it now – this is no area for winging it. I’m harping on this point because a few months back, I chatted with Ariadne. I don’t mean Helios’s granddaughter, but if you knew her achievements, you’d be forgiven for thinking the eyes of Olympus were upon her.

Ariadne is part owner of a firm that analyzes satellite imagery. They launched in the ‘80s, when all thought them mad, until their first oil-industry client popped up. Aria is a third cousin – yes, my family keeps track – and I should have been more amenable back then, because Greeks hire kin.

Ah, well. She’s done swell, and these days they’re getting ready to launch their own satellite. It took them 12 years to build, and it can image… sorry, corporate secret. You know how those go: it got around, and an eager buyer arrived to pay court. Aria says the parties are having trouble agreeing on a value for an asset that could blow up on the Baikonur launchpad. What do I counsel?

Her query resembles a surgeon looking up from the table, elbows-deep in some gullet, and asking, ‘Tom, what’s this thing here? Next to the giblets – throw on a robe and assist.” I do know enough to prevent sepsis, so I floated: “Have they suggested an earnout?”

Aria took a deep breath and put meat on our bones. Yes, but if she and her partners sell out, they’ll lose all control. How can they guarantee the new owners will succeed in meeting the payout targets?

You could always stay on as consultants, I offered. They’ve floated the idea, she said, but what if they marginalize us, stonewall us to death – what could we do?

I nearly tried answering, but Aria had already consulted. “We need to maximize the upfront payment, and not use net income to measure our payouts. We’re standing firm on gross profit – they can’t skata that one so easily,” and now you’ve learned scurrilous Greek.

We don’t talk like that in Galata, but in her clan’s hometown, Dardanéllia, standards were different. Note the past tense, as the 1911 earthquake flattened said town. The gods do have ears.

I had one pearl to dive for: whatever you agree, make sure you have ‘Right to Audit’. Where I learned that, I don’t know, but it deserves capitalization. Most court disputes over earnout contracts rest on loggerhead calculations of the performance of the benchmark metrics that guide the seller’s payout. The fights between Greeks and Turks over who invented those wonderful, aromatic coffees pale in contrast.

“I’ll get more hands-on with our advisory team,” promised Aria – a rare case where I was as wise as my kin.

Aria thinks the deal will go through, and once it does, she wants to hear no more about it; it’s time for retirement, she says. Where to? Why, Lavrakas Beach on Gavdos island, if you please.

So it’s all in the hands of the lawyers. ‘And thus the gods rule humanity’s fate’, I offered. “Yeah,” said Aria, “that’s just what I was telling my partners.”

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