In part one, I listed six out of the 11 reasons why a technology (or other) business owner should consider an earnout as part of his/her sale transaction structure: 1) earnouts offset your historic small sales; 2) buyers' multiples are at pre-1992 levels (and the implications of such); 3) investors' skepticism tends toward a better price for you with an earnout; 4) buyers like sellers willing to share post-closing risk; 5) getting part of a watermelon is better than all of a grape (and what I mean by that); and 6) there is a guaranteed multiple with an earnout. Here are the final five reasons to consider an earnout:
#7 Earnouts More Attractive to Buyers Who Need Their Cash
Strategic corporate buyers are reluctant to use their devalued stock as the currency of choice for acquisitions. Their preferred currency is cash. By agreeing to an earnout, you give the buyer’s cash more velocity (ability to make more acquisitions with their cash) and, therefore, become a more attractive candidate with the ability to ask for greater compensation in the future.
#8 Earnouts Help Break Negotiations Impasse
The market is starting to turn positive which reawakens sellers’ dreams of bubble-type multiples. The buyers are looking back to the historical norm or pre-bubble pricing. The seller believes that this market deserves a premium and the buyers have raised their standards, thus hindering negotiations. An earnout is a way to break this impasse. The seller moves the total selling price up. The buyer stays within their guidelines while potentially paying for the earnout premium with dollars that are the result of additional earnings from the new acquisition.
#9 Improving Markets Support Hitting Your Earnout Targets
The improving market provides both the seller and the buyer growth leverage. When negotiating the earnout component, buyers will be very generous in future compensation if the acquired company exceeds their projections. Projections that look very aggressive for the seller with their pre-merger resources, suddenly become quite attainable as part of a new company entering a period of growth.
An example might look like this: Oracle acquires a small software company, Company B, that has developed Oracle conversion and integration software tools. Last year, Company B had sales of $8 million and EBITDA of $1 million. Company B had grown by 20% per year. The purchase transaction was structured to provide Company B $8 million of Oracle stock and $2 million cash at close plus an earnout that would pay Company B a percentage of $1 million a year for the next three years based on their achieving a 30% compound growth rate in sales. If Company B hit sales of $10.4, $13.52, and $17.58 million, respectively, for the next three years, they would collect another $3 million in transaction value. The seller now expands his/her client base from 200 to 100,000 installed accounts and his/her sales force from 4 to 5,000. Those targets should be very easy to hit. Let's assume that through synergies, the buyer improves net margins to 20% of sales and the acquisition produces $2.08, $2.70, and $3.52 million of additional profits, respectively. They easily finance the earnout with extra profit.
#10 Earnouts Get You Compensated Before Window of Opportunity Closes
The window of opportunity in the technology area opens and closes very quickly. An earnout structure can allow both the buyer and seller to benefit. If the smaller company has developed a winning technology, they usually have a short period of time to establish a lead in the market. If they are addressing a compelling technology gap, the odds are that companies both large and small are developing their own solution simultaneously. The seller wants to develop the potential of the product to put up sales numbers in order to drive up the company’s selling price. They do not have the distribution channels, the time, or other resources to compete with a larger company with a similar solution looking to establish the industry standard.
A larger acquiring company recognizes this first-mover advantage and is willing to pay a buy versus build premium to reduce their time to market. The seller wants a large premium while the buyer is not willing to pay full value for projections with stock and cash at close. The solution: an earnout for the seller that handsomely rewards him/her for meeting those projections. He/she gets the resources and distribution capability of the buyer so the product can reach standard setting critical mass before another large company can knock it off. The buyer gets to market quicker and achieves first-mover advantage while incurring only a portion of the risk of new product development and introduction.
#11 Earnouts Can Save You Tax Dollars
You never can forget about taxes. Earnouts provide a vehicle to defer and reduce the seller’s tax liability. Be sure to discuss your potential deal structure and tax consequences with your advisors before final negotiations begin. A properly structured earnout could save you significant tax dollars.
Reasonable Earnouts Significantly Improve Your Transaction Value
Smaller technology companies have many characteristics that make them good candidates for earnouts in sale transactions: high growth rates; earnings not supportive of maximum valuations; limited window of opportunity to achieve meaningful market penetration; buyers less willing to pay for future potential entirely at the sale closing; and a valuation expectation far greater than those supported by the buyers. It really comes down to how confident the seller is in the performance of his/her company in the post-sale environment. If the earnout targets are reasonably attainable and the earnout compensates him/her for the at-risk portion of the transaction value, a seller can significantly improve the likelihood of a sale closing and the transaction's value.