I am sure you remember the ebay-Skype deal where ebay coughed up $2.6b upfront for Skype and offered an earnout of up to another $1.7b for hitting performance numbers. Besides the value of the deal, what struck me most was that 40% of the total potential deal size was based on performance-based milestones. Fast forward 2 years later and in the day of reckoning it seems that eBay is only going to pay $530mm of the $1.7bb earnout (see Eric Savitz from Barrons post and press release). I am not going to comment here on whether or not the Skype deal was a complete failure for eBay, but rather I thought I would more importantly share my thoughts on earnouts in M&A transactions.
Quite simply, be wary of performance based earnouts unless you get significant value upfront. Many times an acquiring company may say that they can’t pay higher than a certain value for your business but if you perform they can pay alot more. In other words, they want you to put your skin on the line and also incent you to stick around. That is fine as long as you get more than enough upfront for your business so that any dollar from earnouts is just pure upside. If you feel that you are not selling for enough and that too much is tied in the earnout, then trust your gut and either rework the deal or walk away.
Earnouts in theory sound great – the better you perform the more you get. However in practice it doesn’t always work out well. First, earnouts could potentially put the acquiring and target company at odds by creating potential perverse incentives for the acquiring company. Hmm, the company I just bought is doing great but I don’t really want them to hit it out of the park just yet so I may delay giving them their marketing dollars? You can obviously think of a bunch more examples on this front. More importantly, though, I feel that unlike a startup, you have relatively little control of your own destiny. In any M&A with performance numbers, the acquiring company will say it is offering all of these resources and distribution and therefore the revenue, profit, and customer targets should be quite high yet attainable. In a startup, if you fail it is your fault. As part of an operating business or larger entity that isn’t always the case as you are most likely dependent on the acquiring company for resources, distribution, and cash to grow and deliver on your promises. Big companies move slow and you are more likely to not get the support you need in a timely manner meaning that realizing your earnout becomes a very tough proposition. Even thinking about the ebay-Skype saga, I can remember reading the countless news items and stories about how the 2 cultures clashed, how ebay did not understand the Skype business, and the management changes and reorgs that took place. All that being said, I am sure the investors are bummed about leaving another $1.2b on the table in earnouts but at the same time they are still ecstatic about the initial $2.6b they received upfront.
I would advise entrepreneurs against taking earnout based deals. I speak from experience.
There are just too many ways you can get screwed. I dislike earnouts because they effectively turn you into the acquirer’s bank, except you are an unsecured creditor! If they are so confident that the deal makes sense, let them go out and arrange whatever financing is necessary to make the deal happen. Otherwise it is a waste of your time, and odds are that you’ll never see most of what is promised.
Very good post – leaving the argument as to whether or not eBay/Skype was a good idea, and focusing on
“I am sure the investors are bummed about leaving another $1.2b on the table in earnouts but at the same time they are still ecstatic about the initial $2.6b they received upfront.”
I don’t think the Skype founders and investors are too terribly upset about this 😉 – I would imagine the negotiations (originally) and this time went something like “they want to give us what? are you serious? hurry sign it before they change their minds”
Ed, Excellent post – and I mostly agree with your assesment. The key parameter as you suggest – is that you need to be *wary* of earn outs but not necessarily avoid them. To the extent you can get pretty close to your ideal valuation in up front compensation an earn out can provide a great “signaling” benefit as a part of the acquisition negotiation.
If you are very careful in constructing the rules of engagement around an earn out often times you are at an advantage because (i) you are keenly focused on this issue where the person you are negotiating with may be less focused and therefore disadvantaged; (ii) often times if you are being acquired by a larger but slower growing entity and you are growing at a faster rate even with throttled down resources a smaller entity inside of a bigger franchise (with sales, mktg and support resources) can grow beyond the frame of reference of the acquiring entity and (iii) on the signaling side it has a great way of reducing the percieved risk(s) associated with an acquisition from an acquiror point of view-think in terms of vc’s liking to invest in situations where management has pretty big skin in the game versus cashing out. I realize, that comparison is a little apples and oranges but it is instructive around shaping the cadence of the acquisition negotiation if you can signal that management is bullish on the future performance of the entity to be acquired.
Keep your excellent posts coming!!
Ed:
Great thoughts — but I’m sure that the lack of synergy between the two had not a little but A LOT to do with why these earnouts didn’t panout.
This is a classic square peg/round hole acquisition. We’re eBay, well sell stuff, let’s find a phone company and sell more stuff through it. Huh?
Juxtapose this with Nokia buying Navteq yesterday — we’re Nokia, we sell little devices that people take with them everywhere, let’s control the map data that sits on those devices. That’s synergy that can be easily explained.
So your entrepreneur should probably be less worried about earnouts — while important, if they’re doing a deal that just seems, well, odd, then yes, they need to look at “all upside”…
Dave
Earnouts are generally pretty terrible. They are a drag on negotiating a transaction because the seller will want many protections to safeguard the value of the earnout, while the buyer will want complete flexibility to integrate and manage the target — so pictrue hours and hours and hours negotiating, tons of brain damage going through the “what ifs”, lots of talking in circles with the other side, and tons of lawyer time increasing the cost of the deal. Earnouts create bizarre incentives where, depending on the structure, the seller will do everything to maximize the earnout where the buyer may not want to because the things they have to do to maximize the earnout would be contrary to the best interests of the overall organization. And they are almost never concluded without dispute — they are, in effect, an invitation to a lawsuit.
For a seller, in evaluating a proposed deal you should view the amount paid at closing as the determinative amount, with the earnout as merely gravy. More often than not, even if the earnout is very doable, you are not likely to see much return on the earnout. For a buyer, they are good leverage but you will make happier sellers and better integration if you avoid them altogether. Pay up front or don’t pay at all.
I probably agree with what you say b ut could not bring myself to read beyond the first paragraph. Please note that “alot” is not a word and that “incent” is not a verb!