What is an earnout and how earn-outs in acquisitions work? Should you have one in your term sheet? What key terms do you need to watch and negotiate as a founder selling a startup?
If you thought selling your own product was a challenge, welcome to a whole new world of selling fun. You’ll never sell anything as complicated as a startup.
This may make those Einstein proof mobile phone bills and plans of yours look like elementary math and as basic as a paper cup at your childhood lemonade stand.
One of the fun quirks of getting acquired are earnouts. They can be a nightmare. As well as a goldmine opportunity to double the size of your exit. Here’s what you need to know about them.
So How Earn-Outs in Acquisitions Work?
An earn-out is one of those quirky and controversial clauses in your term sheet that can either rob you blind for millions of dollars, or multiply your exit price. It’s all in how you use it, and what you negotiate.
As the name suggests, an earn-out gives you the chance to earn additional money out of the deal. This is typically done by achieving specific milestones and targets after the sale is completed.
More recently, some professional high volume M&A departments are simplifying this, and are making it time-based, rather than performance-based. Usually spread out for several years after the closing.
What’s the Purpose of an Earn-Out?
Some of the individuals that act as an M&A advisor might argue that an earn-out is the ingenious brainchild of some lawyer or Wall Street wolf, intended to enable acquirers to get out of paying the cover price. That may be true, but it can also be a great tool for maximizing the value of your startup and what you’ve built.
From a buyer’s perspective, an earn-out reduces risk, makes the cost more palatable, and may create a massive discount on purchasing your company.
In the example of a strategic acquisition, when thinking how earn-outs in acquisitions work it basically gives the buyer a chance to test drive the merchandise, get integration achieved, and secure the profitable performance you sold them on in your pitch book.
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They can use the enhanced proceeds of their new acquisition to pay you back over time through the earnout clause. If your assets fail to perform for them, then they don’t have to pay anything else.
From a buyer’s perspective, it can at first be difficult to see any sense in why you would take an earn-out. However, if you really believe your venture and this new merger can produce even bigger things and continue to grow, an earn-out gives you a chance to get paid even more for proving it.
For example; you may see your startup’s potential as being worth $1 billion. Your current financials and track record over the past couple of years may only justify $500 million in value right now. You can agree to an earnout for the additional $500 million over the next three years if with the new resources you’ve gained you can hit the stats and claims in your M&A pitch book.
The Pros & Cons of an Earn-Out
From a founder’s perspective, there are clear advantages and disadvantages when thinking about how earn-outs in acquisitions work.
- A chance to sell your startup for far more
- The opportunity to prove value, with more resources
- The prestige and credibility that comes with a larger exit
- The odds you’ll never see a penny of earnout money
- The commitment to continue working as an employee for years
- Being in limbo rather than bouncing forward to your next project
Defending Your Earn-Out
If you’ve done your homework on M&A deals, you already know that the chances of your venture being successfully assimilated or continuing to thrive as its own entity after a sale are pretty slim. Put nicely, the odds are pretty terrible.
That is even when all the intentions are good and best efforts are made and the markets are kind. Integration is just challenging. Most of the time it is trying to figure out how to get that square peg in the smaller round hole.
Then, no doubt there are sadly probably some acquirers who see an opportunity to use earn-outs to grab your business at a nice discount. If you can’t hit your milestones and targets, they don’t have to pay you. They can choose to make it very difficult for you to achieve them.
Even when this is not intentional, it is going to be more challenging than you think and is used to. You might be on a great growth trajectory right now. You might see a merger or the credibility of being linked with this bigger company, the resources they have and access to more money as a super-easy way to catapult your startup to the next level. That can and has happened. If you want access to an extra billion users tomorrow, just get acquired by Facebook or Google.
However, as an employee (regardless of your new title), and especially in a large company, your ability to actually achieve anything might be pretty close to zero. You might not get the budget or team you thought. You might not get plugged in as you thought. Your new accountants are going to play your books a whole lot different than you would as a founder.
If you are at the point of figuring out how earn-outs in acquisitions work, make sure you negotiate:
- Your budget
- Your new executive team
- Performance-based on top-line revenues or sales, not profit
- Enough cash in the bank to legally fight back and defend your earnout
- Enough cash upfront to be happy without getting a penny in earnout dollars
Earn-outs may or may not be ‘standard’ in your space, but you can and need to negotiate the finer points and nail them down on paper if you are going to go for the gold and see your startup through to the next level and bet your finances on it.