If/when you sell your firm, it’ll likely be the largest transaction of your life, and so it makes sense to understand it! In this episode David gives a crash course in everything earnouts.

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"Understanding Earnouts" by David C. Baker for punctuation.com

Transcript

Blair Enns: David, our topic today is Understanding Earnouts. What is an earnout?

David C. Baker: First of all, let's just clarify that the audience has been clambering to understand earnouts.

[laughter]

The numbers drop.

Blair: Yes.

David: An earnout is when you sell your company, it's split into two parts. You get a certain amount of cash at closing. Then the second part, everything you don't get in cash at closing, is an earnout, and that's what you get over time if you hit certain performance targets. If you are selling your firm, it's probably the only time you'll do it. It's probably the biggest transaction of your life. Everybody knows what an earnout is, basically, but I'm trying to give people a 25-minute seminar on earnout so that they go into that possible transaction a little bit more intelligent about what's going on.

Blair: Point of clarification. If I never sell my business, nobody is ever going to give me an earnout, correct? [chuckles]

David: You did not have to say that at the beginning of an episode, but that is absolutely true.

Blair: All right.

David: It's an incentive.

Blair: It's an incentive if you sell your firm. I'm trying to have fun with this topic. You and I have been in this business a long time, well over 50 years combined. I remember way back people started selling firms, and earnout was like, "Oh, yes, it's a whole bunch of money but it's on an earnout." Then you'd think, "Well, good luck to you." Tell us a little bit about the history of earnouts without boring the shit out of us. It hasn't always been this way, has it?

David: No, it hasn't. There have been earnouts in our industry for at least 40 years, like there have been earnouts elsewhere, but they've changed significantly. In the history of earnouts, if we go all the way back to Abraham's lemonade stand, that's where entrepreneurship started. There were no earnouts. You bought a glass of lemonade for Abraham and you got paid. In the history of business, earnouts are a very new thing, like from really the '80s on. They've been true in our field as well. They've changed significantly. Now they're three years at the most, sometimes two years, sometimes one-year, sometimes you get all the money in cash at closing.

In the past they were five years. Earnouts didn't come along until about 40, 45 years ago, and it wasn't driven by buyers, oddly enough. You would think that buyers would say, "Listen, I want to protect my downside if this goes bad," but that wasn't really what happened. It was investors that were behind the buyers that said, "Okay, buyers, you want to start paying more for companies, we get it." Now you're saying, "Okay, we're going hedge out bet, and we're going to pay more for companies," but the more we're going to pay is going to come at an earnout."

These investors behind the buyers were saying, "Listen, we got to have a little bit more structure here. We have to have a little bit more certainty. We have to have these things structured very carefully." Which was a benefit to the buyers and the sellers too, because they benefited from knowing more about that. Earnouts are the last 45 years. Before that they didn't happen very often.

Blair: We went from no earnouts to five-year earnouts and then that timescale seems to have scaled back? It's now one to three years, is that correct?

David: Right. Every once in a while we'll have a deal that we do where there's very little of the purchase price paid in an earnout. Like we did one, I think, it was three years ago where we were representing the buyer. The person selling the firm was going to have an appointed post in the US government. They could not have any conflict of interest, and an earnout is a conflict of interest, because the seller would have some incentive to send business his way in order to get the most, and that couldn't happen, and so we had to structure it.

That happens every once in a while. When you sell to a client, like if you have a client concentration issue, and you sell your firm to an existing client, there is not an earnout there, but in almost every case there's an earnout. It's never more than three years and sometimes it's shorter. Sometimes the earnout doesn't have to be the same for each partner. They can be different based on what the buyer is looking for.

Blair: You want to walk us through the basic elements of an earnout? One of them is the time period that we talked about.

David: It's really pretty simple. There's the time periods, so how long will this last? The second would be the formula for calculating the payment. The third is any dependencies, like what has to happen for you to get this earnout. I just want to pause and say, the M&A market is so much better in almost every respect than it used to be. This is another area in that the earnouts, not only are they shorter, but they're so much simpler. You don't have these complicated spreadsheets about how you get them and accelerator clauses and all this stuff. It's like, "No, this happens and this happens," so it's much simpler, but it's always involving those three things. What's the formula, what's the time period, and what are the dependencies in order for you to earn this? That would be the basic structure.

Blair: The formula's typically based on, maybe this is the dependencies. It's usually a measure of, is it top line revenue, bottom line, or somewhere in the middle, gross margin? One of those three things?

David: It all depends on what the buyer is nervous at all about. Sometimes it's top line. Sometimes it's bottom line. Sometimes it's neither. Sometimes it's just growth rate that you maintain. Sometimes it's retention of a certain client base. Sometimes it's like, did you get this approval? Did you get a registration with a patent and trademark office through that helps retain the value of this asset that we're purchasing and so on? Usually, it's tied to something around profitability because profitability, unless it's a strategic purchase, is what's going to drive an acquisition price. They just want a little bit more certainty around profitability, so often it's tied to that too.

Blair: In your most recent book, Selling Your Professional Services Firm, you talked about earnouts. I think you told a story about the earnout dependency was not tied to the overt reasons for the purchase. Am I speaking about that correctly?

David: Yes. That's why in the early conversations that you have with a potential buyer, if you're selling your firm, you want to nail down, like, why are you doing this and why are you choosing our firm? You memorialize that so that you're all agreeing like this is driven by such and such. In the example I think you're referring to, it's like, "We're a coding firm and we need a recruiting presence in Austin." That's one of the things that's driving this acquisition. You record this and you memorialize it, and then later during the negotiations, they start beating you up because you're not all that profitable. Then, you have to remind them it's like, "But we're still in Austin."

That was what was driving this thing. You have to memorialize that and surface it early on. This is where you have to be really careful about aligning the incentives with what you think the company is going to ask of you. Let's say that they're nervous about the profitability path that you've been on. Well, they're not nervous about it because you've demonstrated, but they're nervous about whether you can keep it up. They say, "Listen, we're going to keep the books on your firm separate and your earnout is going to be dependent on your continued profitability."

What you love about that is you have all kinds of control over that, and you're not worried about hitting those because you know your firm really well. Now, the transaction happens. Now, they see how successful you are, and they see how you could impact other areas of their business. They start asking you to help, and because you're a team player, you say, "Sure." Then it dawns on you like, oh, wait, my earnout is not dependent on how these other divisions do so how does all that play in? Especially if I start to take my focus off of the company they purchased and I focus on helping other departments, how's that going to help me?

You have to think far ahead. Either that or you have to have a buyer who's open to changing these arrangements so that the incentives align with where they're asking you to focus. It's a big game you have to think about, and that's where an advisor can help you think through what they're going to expect of you. If you don't think that the prospects that you have on your own are very strong, well then, you're going to fight for an earnout that's tied to the overall performance of the bigger company. That gives you the freedom to not focus exclusively on your little sandbox after the acquisit