Caution: Earnouts Ahead

Tying price to performance can be a good way to acquire hard-to-value companies -- if you're careful.

You’ve valued your target fairly, and your acquisition is almost complete. But you still don’t buy the sellers’ unbridled optimism about their own prospects. If you’re like some acquirers, you might design an earnout — a performance-based component of the final price — to bridge the gap between your projections and theirs.

Besides allowing both parties to “agree to disagree” on elements of the valuation, such contingency terms usually create incentives for managers to stay on and work hard after the acquisition. Earnouts also spread the risk in a deal. Robert Bruner, a finance professor at the University of Virginia’s Darden School of Business Administration, explains that they function very much like a call option, “letting the buyer commit a little money, and then wait and see what the outcome is.”

Most experts believe earnouts have a useful place in the mergers-and-acquisitions toolbox, if perhaps limited to certain types of smaller, nonpublic deals. Be careful, though. CFOs who have used them warn they can be dangerous if handled improperly.

Contingency terms are found in 4 percent of all announced U.S. deals — closer to 10 percent of deals valued at or below $250 million. More than 200 acquisitions have contained earnouts in each of the past five years, with the total value of the transactions peaking at $27.9 billion in 2000.

Professor Bruner suggests that their increased use of late reflects the rise of intangible assets in M&A valuations, and the need for seller and buyer to work out the pricing disagreements that intangibles can cause. Earnouts are most often considered “in the case of young companies, unproven new technologies, unmarketed artistic or creative assets, major new products or geographic markets — anywhere there is a great deal of uncertainty about the future,” says Bruner. And they are sometimes the sole basis of payment for distressed properties.

Among the current crop of earnout deals is E-Trade Group’s purchase of online trading platform Tradescape Corp. for $100 million of E-Trade stock, a price that could grow to include shares worth another $180 million. “If we have to pay out that extra amount, we will be very happy,” says E-Trade CFO Len Purkis, noting that Tradescape must reach both “aggressive earnings targets and revenue goals” for that to happen. Tradescape’s owner-managers, of course, would cheer also, since they would earn the big contingency payment.

Earnout Burnout

So what are the hazards? For one thing, if poorly structured, earnouts can lead to opportunistic behavior by the seller-managers as they try to trigger their hefty payouts. It’s “poison to structure an earnout for only a short period of time,” notes Bruner, citing a term of one year or less as a common cause of trouble.

Baltimore-based Sylvan Learning Systems Inc. certainly found it so. The company, a prolific acquirer of educational companies in recent years, started out by setting up one-year earnouts. For the managers Sylvan retained, “the natural response was to go gangbusters in terms of revenues, and not spend for future growth,” says senior vice president and CFO Sean Creamer. Sylvan now designs earnouts for three years or more, and monitors the deals carefully, sometimes using special audits to make sure the managers aren’t “gaming the system.”

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