Ben T. Smith IV, co-founder of Merchantcircle.com & Spoke.com (btsiv.com), discusses the four key issues of an earn-out when selling your company. The tips of an earn-out discussed will further help during the selling process.
- Ability to deliver results after exiting the company
- More complex deal structure
- Earn-outs have significant tax considerations for the seller
- Determining the value split of the earn-out
Having bought a number of companies, the process always comes up of we want to do an earn-out where you if you deliver certain results we’ll pay you more money. It’s a good way of bridging the gap between what the buyers thinks an asset is worth, and what the seller thinks it’s worth.
The problem with earn-outs is four-fold. The first is are you really going to have control to delivery against that earn-out that you had when you were the founder and CEO. If you don’t have that control, you should be really careful of signing up for one because you’re probably not going to end up getting in, and just kind of create a lot of ill will in the process.
The second is the enormous complexity of implementing that transaction and a set of deal contracts. Once you define the earn-out you’re probably increasing assuming you actually want to get the money at some point of time. You’re probably increasing the level of expense—transaction expense by a factor of 4. Anytime you increase the transaction expense by a factor 4, you’re increasing the time that it’s going to take to get that deal on significantly, and we all know no deal ages well. So an earn-out oftentimes can start a process that will actually kill a deal when you thought it was processed to help a deal happen.
The third thing you should think about earn-outs is how they’re handled from a tax perspective. Earn-outs often times are implemented as earned income. Not as a capital gain on your asset, but as earned income. And no that they aren’t income if you obviously with a tax law of how it is could have significant difference in terms of what your payout is going to be. So you really have to consider the tax implication of earn-outs.
There is also complex tax and income statement issues for a public company in doing an earn-out that makes a lot of CFOs not want to do an earn-out. So it actually can have a lot of complexity to the deal.
The fourth thing that really considered about earn-out where I see a lot of these things come apart is how you split the value with earn-out. The investors are no longer involved in your company and they are no longer own the board. They no longer have any ability to help you be successful or not. Yet, are they participating in that earn-out or they not? If they’re not, then they’re going to want more of the upfront payments, which is going to cut your upfront payment. If they are, then you are really working for them afterwards and you have a lot of obligations to them even if you don’t have fiduciary obligations, you still have a lot of personal relationship obligations to do your absolute best. So if you accept an earn-out and then decide it’s really not working for you so you want to bolt, you’re leaving your investor’s money on the table.
Now I’ve seen earn-outs work incredibly well. I sold out a company that I was involved with another guy was a founder of called Mesmo which we sold the game show network. The earn-out worked out incredibly well. But I’ve also seen earn-outs end up in court which is where most end up.
When someone approaches me with earn-out as a seller, I really try to understand what they are trying to understand and what risk they are trying to mitigate and try to solve that risk in a different way because the better answer is to get a full value price and really avoid the earn-out and see the earn-outs as just upsize and bonuses for your team that helps the asset to be successful versus having the earn-out turning to be something negative.