Making earn-outs work

Marcus Anselm: a partner at Clarity
Marcus Anselm: a partner at Clarity

Marcus Anselm, a partner at the corporate finance advisory firm Clarity, explains that when it comes to earn outs, there is lots for both sides of the table to think about.

Any agency founder thinking of selling his or her business needs to think carefully about how to structure the earn-out. Get it right and it's a win-win for everyone. Get it wrong and you could find yourself locked into a partnership that works for neither the buyer nor the seller – and having to re-negotiate terms.

As corporate finance advisers focussed on the media sector, Clarity has to wrestle with these issues all the time. In some ways the earn-out (creating the incentives to ensure your business continues to flourish within its new owner) is one of the most important aspects of the deal.

Earn-outs are particularly common in marketing services, unsurprising given the most valuable assets walk out of the door each day.

More than just being a form of protection/lock-in, earn-outs are a means to bridge value, between the amount that you, the vendor, want for your business, and the amount that the buyer is willing to pay.

By helping vendors to achieve their goals, if the business delivers on its promise, earn-outs can allow both sides of a deal to get what they want.

Earn-outs tend to be paid in cash although some groups offer a share alternative. They typically run for between two to five years, sometimes longer.

Payments are usually linked to financial metrics including revenue, profit margin and growth. It is not unusual for the earn-out to be worth the same, or more, than the initial payment, so it is important to get this right.

Be realistic about your projections. Forecasting growth at a rate never previously achieved will make the payments look good on paper, but unlikely to materialise in practice. Make sure you run a proper sensitivity analysis, and consider the outcomes both if things go well and if they don’t go to plan.

Consider how your business, and its finances, will be affected by being part of a different entity. At the most basic level, you need to check that you understand how your new owner calculates profit. Are the accounting policies the same as yours and, if not, how does this affect the earn-out calculation?

What is the approach to referrals? Your new owner is not going to be excited about paying a multiple on revenue it has referred to you. Equally, if it could not have undertaken that work without you, then value should flow your way.

Will you have to pay a group management charge, to employ more people in your finance team to cope with new reporting requirements, or be required to move offices?

Increased costs may quickly turn attractive deferred payments into something fairly ordinary. You need to have comprehensive protections in place to ensure the new owner cannot frustrate the earn-out.

You also need to think about how you are going to incentivise your staff within the new parent company, particularly those who are not shareholders when the transaction completes.

Think about this issue well in advance and set aside some equity for your key talent. It is not something you should be thinking about for the first time in the run-up to a transaction.

As with everything, the devil is in the detail. On one level, an earn-out is a simple mechanism but the subtleties can be all important.

There is a lot to think about in devising an effective structure, but with a bit of care, and good advice, you can achieve the financial result that you desire and create an earn-out that encourages the "right" behaviour from all key individuals.

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