Earn-Out Payments and Retention Payments
In my last transaction documents blog post – before posts on credibility and premium valuations as well as a post comparing free solo climbers and bootstrappers – I continued a section by section analysis of an asset purchase agreement with an intro to ‘Purchase and Sale of Acquired Assets; Assumption of Assumed Liabilities’. Today, we will discuss ‘Earn-Out Payments and Retention Payments,’ frequently a critical component of the total consideration in a deal.
An earn-out is comprised of conditional supplementary payments incorporated in a stock purchase or asset purchase agreement. Because earn-out payments are contingent on the future performance of the acquired company, they are not included in the purchase price. An earn-out is most common when buyers and sellers are having an especially difficult time coming to agreement on valuation terms, but believe that the fit is strong otherwise. The fact that a company’s “value” is derived from so many variables means that earn-out discussions can start in a number of ways,, including the following primary cases, among others:
- A difference of opinion about future prospects. Sellers tend to be bullish on a business’s future prospects while buyers tend to be more metered, particularly because a buyer naturally wonders what information the seller has that leads him to want to sell. In such cases an earn-out is a great way to bridge the gap. If a seller expects $(X) in revenue over (Y) years post deal and a buyer expects $(A) in revenue over (Y) years, a willingness by a seller to take a portion of total consideration only if actual performance in future years is between (A) and (X) is a tremendous signal to a buyer. Similarly a buyer’s willingness to structure an earn-out is a strong signal that its valuation-reducing concern truly lies in perceived future performance and not something else.
- A difference of opinion about market dynamics. In the case where a seller operates in a risky market that a buyer is not currently executing in, the buyer may want to pay a lower amount to account for the perceived endemic market risks (regulatory, political, or IP are common). However, a seller may believe that their market is in no real danger from any of these threats. In such cases, an earn-out can also be a great way to bridge the gap. In my M&A practice, I often call the category of earn-out that might be employed in such a case a “drop-kick earn-out.” This is because we base the earn-out on the business simply not falling to pieces vs. excelling. Often, such an earn-out would pay a fixed amount over a number of years if entity revenue or profit remains at least flat…i.e. the business does not crash and burn due to regulatory, political, or other market upheaval.
- Buyer fears founder exit post transaction. In businesses where management talent is important to the future prospects of the company, buyers logically fear that writing a large check to managers that are also owners will incentivize a management exodus. In such cases, an earn-out is a very obvious mechanism for keeping management incentivized post transaction. A second category of contingent payment often used when management flight is feared is known as a retention payment, or a payment based solely on a founder/manager continuing to be employed at the surviving company at the end of certain time periods post closing. Often, a combination of retention and earn-out payments is ideal to incentivize desirable founder/manager behavior post deal.
In theory, an earn-out is typically fairly simple. However, in practice, structuring the right earn-out can be very complicated, particularly where many and varied interests are involved. While it is impossible to capture the universe of important earn-out-related considerations and contingencies in a relatively short blog post, I am always happy to serve as a sounding board to anyone reading that would like additional guidance regarding earn-out payments and their role in M&A. Please reach out if you’d like to engage in a longer discussion about the nature of earn-outs and how to most effectively use them to align buyer/seller interests in a transaction.
For my clients, the negotiation of earn-out and/or retention payments is just one of many services that are part of a typical engagement. In a future post, we’ll discuss how a credible M&A process and associated advisor | client team messaging related to management’s growth-driven interests + passion can reduce the chances that buyers push for retention-heavy structures. There is much that can be done in this arena to optimize terms and my firm has been very successful in driving cash heavy (low earn-out) transactions with top-of-market revenue multiples (15x+ in more than a few cases). Down the road, I’ll also likely add posts that provide examples (from my past deals) of earn-out and other retention mechanisms as well as content that details some of the nuances related to such structures. However, for now, I am going to get to some more of my weekend activities with my family.
Also, as always, please make me aware if you’d like me to dive into additional detail on certain components of an earn-out or about common pitfalls in transactions with an earn-out. I am always happy to honor requests!