An earn-out is a commonly used pricing mechanism in M&A transactions where the seller of a business will get additional compensation in the future if some predefined business goals are achieved. Earn-outs are a useful way to bring the buyer and seller together when there is a difference of opinion on valuation. For the buyer, an earn-out is a risk reduction to hedge against overpaying and also has the advantage of deferring the payment. For operationally-involved shareholders, an earn-out is a great way to increase the sales price of their business. Earn-outs include some core elements like setting financial or non-financial targets, defining rules for the collaboration, and determining how these targets are measured, how the payment is structured, the time period of the earn-out, and many more details. This article is not about that.
As earn-outs have been more common recently in the VC space, this article is about a strategy that financial sharks, usually private family offices or smaller PE funds, occasionally use to screw founders. If you are an entrepreneur with ambition to sell your company, you better read this!
This is a short story about a team of European founders who have caught the eye of a private investor (let’s call the investor “the Fox”) who wants to buy their company.
Step 1: The Deal (Day 0)
The founders, the board, and the current investors of the company are quite excited about the Fox’s interest in their company. Several talks with the “Chief Fox” have built immense confidence. The Fox’s plan is to bring the company to the next level: international expansion, new product lines, M&A transactions to buy startups, and even an IPO will be no problem with help of their network and expertise. And all this while the two founders continue to be in charge.
The deal for the founders is a 3-year earn-out with a 1-year cliff, with additional millions for the founders if they achieve certain high but achievable milestones. The requirements only include a few new tasks that the founders haven’t done before. They think, “We are totally aligned with the Fox, and it is only three more years running the company. What can go wrong?” For them, it is a definite go.
For the investors, the Fox offers a low but still moderate valuation, which is high enough to convince 51% to sell their shares. Because of the drag-along clause, the minority shareholders have to follow and the deal is done.
Step 2: The Honeymoon (1–2 months after the deal)
With a new owner, the board obviously changes. That means, the “finance guys” from the Fox will run the strategy going forward. Everybody is polite, they visit the company frequently, and rapidly get to know the firm inside out. The founders regularly exchange emails with the Chief Fox, where both empathize how great the relationship is. The founders think that the three years will be a piece of cake.
Step 3: The Vise (2–5 months after the deal)
Once the board truly understands all levers of the company, they increase the pressure. In all board meetings and monthly KPI calls, the founders get destroyed. The finance guys criticize every little deviation from the plan. Especially with the new tasks, which the founders have never done before, they show no mercy as the traction is not quite as projected.
Looking at the situation objectively though, the numbers are quite good. But no matter how hard the founders try, the finance guys give the founders the feeling that they are still failing. This leads to the founders’ motivation and energy levels dropping. Further, the Chief Fox calls to tell them that he expected more of them.
Step 4: The COO (5–8 months after the deal)
The board decides to “support” the founders by bringing in a COO from the Fox’s team so the company can achieve its targets. Yet this COO has a second agenda. He/she is told that the founders might not be the right people to run the company any longer and that he/she has to learn everything as quickly as possible to be able to become the interim CEO if things get worse.
His/her tasks include looking at and challenging every little part of the founders’ work and asking uncomfortable questions about their work style – basically taking away their freedom of how they run their company. At the same time, the finance guys continue to bully the founders in board meetings and the Chief Fox stops answering their calls and emails.
Step 5: The Surrender (8–11 months after the deal)
Zooming-out: The founders work in the company that they built but do not own anymore. Although they work harder than ever, it seems that they still fail in their new roles. The finance guys have taken away their self-confidence with constant bullying and pressuring. The new COO constantly surveils them and challenges their work behavior. With all this stress, the founders have less time for their employees, which creates distance and a bad environment in the office. Further, all the stress puts pressure on their personal lives, private relationships, and health. They are tired, and all of a sudden the remaining two years seem like an eternity.
The voices from all angles become louder, questioning whether the two founders are still the right people to run the company. Even the board has asked them to consider stepping down for the sake of the company and their employees. Although the valuation of the exit was mediocre, the founders still made some millions on the deal. So, they say f*** it, we are out. Screw the earn-out.
Step 6: The “Happy” End
Although the Fox officially states that they “regret this decision,” they quickly assign their COO as interim CEO and hire a headhunter to find a new management team for the company. For the Fox, the situation is quite good – the company has still hit most of its targets and the company valuation has already increased. They only had to pay a moderate price for the company, and now they don’t have to pay the full earn-out. After 1–2 years, they can successfully resell the company to a larger PE fund, which results in a great return. And then the whole cycle repeats.
In finance, there is no mercy. Founders have to be extremely careful about who they get into bed with. In general, a founder’s objective must be to maximize the up-front cash percentage and alleviate the earn-out terms. But earn-outs will always have their place in M&A transactions where there is no one-size-fits-all solution. For those transactions, you do not need a regular lawyer. You need a lawyer who knows all strategies and drafts your contract correctly from the start, so that such a scenario does not happen to your company.
Venturebruck combines this business and legal knowledge, and we know what dirty tricks you need to watch out for. Contact us!