Around 80% of deals include some sort of earnout agreement, but this is a subject of significant discussion in M&A circles. Generally speaking, these types of deals work out well, but occasionally things can go wrong.
Clearly there is always going to be a chance that an earnout won’t deliver quite as hoped but there are ways in which a vendor can protect itself. So, when negotiating an earnout there are two key things vendors should bear in mind:
- Set realistic targets.
- Ensure that you maintain control over the key factors that might impact on you achieving a favourable earnout. If you don’t have control, then at least ensure you have rights to some sort of remedy.
The core elements a vendor should aim to preserve include branding, employee matters and pricing and payment terms for clients. If you’re selling into a holdco you need to ensure you don’t fall foul of organisation-wide policies that could have an impact on your own performance at a critical time.
As such, make sure your remuneration and incentive plans won’t be curtailed by a network-wide hiring freeze (for example).
Make sure you won’t be drawn into an agreement a buyer has made across the whole group to offer a certain rate to a particular client, which could see you delivering the same work for lower rates or with less favourable payment terms.
Beware of earnouts where terms are dictated by the combined results of your own business with an existing one within the network. While this can present a great opportunity, do consider that if you are being combined with another business, there’s every chance it could be under-performing.
Therefore, it’s hugely important that you and your advisors do thorough due diligence on the business you are to be combined with before agreeing to anything. Always have a clear understanding of what you’re getting into – the group’s offering, its client relationships and its growth strategy.
You must also have faith in the capabilities of your counterpart’s senior management team.
You must go into any deal with your eyes open and that means having a clear understanding of how your business is going to be managed and seen within the wider network.
The simple fact is acquiring groups sometimes don’t have a very clear plan for reporting lines or how the new business will be brought on board. Too often the acquired business is just left to fend for itself and the benefits of joining the larger group fall by the wayside.
This obviously doesn’t work in either party’s favour but the reality can be the buyer simply doesn’t have the senior management resource available to on-board acquisitions properly.
Make sure you have these discussions before you commit to joining a new group to understand how your business will fit into the wider network, what’s expected of you and what additional strains could be placed upon you.
One further key area to bear in mind is slightly grey, and that’s being a good corporate citizen. Let’s consider both the seller’s and the buyer’s motivations. Vendors typically join a larger group because they want to take advantage of joint marketing activity, access a broader range of clients, use international offices and so on.
On the other hand, the buyer wants to acquire a skillset it doesn’t already have, or at least not in-depth. As such, the vendor can find itself in great demand to attend pitches and become involved in business development activities across the new group, which may or may not have any direct benefit on their own company.
Clearly, there’s a balance to be struck between being a good corporate citizen and making sure you have enough time to manage your own business to hit your own earnout targets.
The legal agreements should be regarded as a backstop, mirror image protection for both buyer and seller. Everything must be fully disclosed and, as a seller, you should also have the same rights of compensation as the buyer if you have been misled.
Despite whatever legal agreements may be put in place, trust remains absolutely key. There will always be issues that can’t be set in place in advance of the deal being agreed, but as long as there’s trust and goodwill between all parties then this shouldn’t be a limiting factor.
Keith Hunt is the managing partner at Results International.