Join-ins are better than Earn-outs

August 10, 2011 § Leave a comment

I had breakfast with a fellow entrepreneur and friend recently who is in the middle of a particularly sticky acquisition negotiation.  He is the acquiring company and is having difficulty reaching agreement on valuation for the business he is buying.  In M&A land, when this happens, the most common tool used is called an Earn-out.

Detour – definition of an Earn-out: For those of you who don’t know what an Earn-out is, it is basically kicking the can down the road.  It is an agreement that says we will value your business at a specific multiple of your future performance.  For example, if your revenues are $1 million in 2012, you will get valued at 2x or $2 million.  If they are $1.5 million, then you will get valued at $3 million, etc.  These deals are often done to bridge a deal divide caused by different opinions on a future event, in the previous example, future revenues.  The challenge in an earn-out scenario (i.e. after the deal is closed) is often that the acquiring entity has a lot of control over resources which can make it hard (or easy) for the seller to achieve the earn-out.  And while it would seem ridiculous that a company would acquire another company and not do everything in its power to make that acquisition immediately successful, that is exactly what happens.  I have been on both sides (acquiring and selling) of an earn-out and I can guarantee you this is how it works.  Personally, I hate earn-outs both as a buyer or seller.

End-detour, back to my friend’s story: What is interesting about my friend’s deal is that both sides seem to agree on what revenue and margins the business can do in 2012 independently.  The challenge is that they can’t seem to agree on the value the combined business, which will begin raising money about six months after the deal closes.  The acquirer (my friend) has a strong sense of valuation based on market comps.  But the seller doesn’t.  Adding to the challenge, the two businesses overlap so much, that keeping separate books is impossible, making an earn-out also impossible.  This complexity has led my friend to walk away from the negotiations three times.

We went back and forth during breakfast for a while, before I suggested an idea that might lead to a deal break-through…rather than an earn-out, do a Join-in.  This term, which I made up at breakfast, means base his valuation on the valuation the combined company gets in the market.  The higher the valuation, the bigger the equity stake.  And since the key driver of the company’s valuation is going to be total revenues, tie the seller’s ownership stake to the combined company revenues.  Give the seller every incentive to exceed the revenue goals of the combined entity.  This structure aligns incentives in a way that earn-outs do not.  What is also good about this structure is that it clarifies the sand-bagging that always happens when exchanging financials.  When I finished explaining this structure, it seemed like a light bulb went on for my friend.  Hopefully it leads to a deal.  Good luck friend.

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