Earn-out device lets you make a bet on the future

Published in the San Diego Union-Tribune, July 10, 2017

I am involved in two transactions. In one, I am trying to sell a dog, and I need to get a certain amount of money back to recoup my investment — which is unlikely. In the other, I am buying a dog, and I want to pay very little, so naturally the seller is not thrilled.

“Dog” is a term of art, referring to a company, not an animal.

So I am turning to my favorite device for reconciliation — the earn-out. In practice, an earn-out is used when there is a difference of opinion about value and expected growth rates. The way it works is simple. I pay you X dollars at the close to acquire your company, and I give you some more money at a later date (usually 2-3 years) based on the performance of the company. Or vice versa.

Beware. Drafting the language that deals with the amount I am supposed to pay in the future is complex. There are nuances about determining what is revenue, what is gross, what is net, what is an approved expense, what is a capital improvement, etc. As they say, the devil is in the details. The calculation language really matters. Pay for an attorney who knows what he/she is doing.

In many cases, I love the idea of an earn-out because it allows the buyer and seller to make varying degrees of assumptions. You get to put your proverbial money where your mouth is.

Here is a true story. I sold a company in 2009. The seller wanted a few million dollars, and the buyer said he would only give us $1 million. So we said OK, but if the division — which our seller would continue to run for three years — performed particularly well, then we would get some more dough.

Here is the trick. The buyer figured we were idiots and we could never hit a really big number, so they agreed that if we hit this big number (which they were positive we could never do) then sure, knock yourself out, you can have an outsized percentage of that increase — because it will never happen.

We sold the company, and during the three-year earn-out period, my guys went from $17 million in annual revenue to $82 million, and we all jogged to the bank. We couldn’t run, because the money was too heavy.

In the other case, I am buying a company on the ropes. But they are owned by a public company that does not want to show a loss on its balance sheet, blah blah — so the model works in reverse. We will pay them a dollar to buy it, but gladly give them more money if the dog performs above expectations. They get a contingent interest.

Again, accounting details matter, but in this case, we have an unfair advantage in that we have a team that knows the business and can parachute in on Day One.

Nota bene: In case numero uno, we were in charge of our own destiny. In case duo, they have to rely on our skills.

There is obviously room in that scenario for chicanery and bad behavior to limit the upside, so if you are the seller in case two, you need to have some controls on how they operate the business. Otherwise, the accountants will prove to you that there is no profit. (For further study, please review the legal fine print in the movie business contracts. There have not been any net profit participations since The Jazz Singer.) So, who is managing the business after the close really matters.

What I love about the earn-out is that I get to make a bet on the future — and I intend to have some control over that future.

There is a third case (I am about to sell another dog) in which I need the earn-out to favor me, and in that case I am insisting that two of my managers go with the new buyer, get paid by the new buyer, and a large amount of their personal contingent future payments be tied to the performance of the company going forward.

In other words, I need everyone to have skin in the game. The earn-out is a wonderful way to bridge the perception gap and create a meeting of the minds.

Rule No. 524:  So you think I’m a chuckle head. We’ll see.

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