Q: I am trying to buy a smaller company in my industry, but the negotiations have stalled over price.
It probably won’t surprise you to hear the seller thinks his company is worth a lot more than I think it is. So far we have been talking about doing a straight cash deal, but now I’m contemplating an earn-out to try to bridge the valuation gap. Is this a good idea?
A: For those who aren’t familiar with the term, earn-outs are a form of “contingent contract” that experts often recommend as a way of unlocking value in negotiations. A typical structure for an earn-out is to stipulate that the buyer make one or more future payments contingent on the company’s performance during a set period of time after the sale—say, its ability to hit certain profitability or revenue targets. Earn-outs are popular because (typically optimistic) sellers attach a high likelihood of achieving these future payouts, while (typically pessimistic) buyers will attach a low likelihood of having to pay. An earn-out is a bargain for the buyer, who has to pay only if the performance targets are met. Finally, an earn-out forces a seller to “put his money where his mouth is”—thereby testing the validity of his claims.
However, earn-outs should be used with care because they work only under certain conditions. First, performance metrics need to be clearly defined. This may sound simple, but in the complex world of accounting, revenues or the number of new stores is generally a better performance metric than more malleable measures such as profitability.
Second, the performance metric should not distort behavior. For example, although cash flow may seem like a reasonable performance measure for an earn-out, it can cause the seller (to the extent that he or she has operational control) to under-invest during the earn-out period, for fear of reducing today’s cash flows with investments that will pay off only after the seller is gone.
The conventional wisdom in transactional practice is that earn-outs are either fully paid out or litigated. Unfortunately, this is only a slight exaggeration, and the two main reasons that earn-outs trigger lawsuits are unclear performance metrics and claims of distorted behavior.
Earn-outs have business implications as well. For example, typically a seller will insist that the earn-out be tied to the performance of its business, not the overall business into which it is selling. This means that books and records must be kept separately for the duration of the earn-out period. In many cases, the seller will want to maintain operational control over its business during the earn-out period so that it can work to ensure that the earn-out is achieved.
To see an example of a successful earn-out, consider the example of Sukhpal Singh Ahluwalia, a self-made British entrepreneur. In 2011, he was in negotiations to sell the company he had built, Euro Car Parts (ECP), to LKQ Corporation, a larger U.S. company in the same industry. (I later joined the board of LKQ, but only after this negotiation had been completed.)
Like many entrepreneurs, Ahluwalia was convinced that his company was worth more than LKQ was offering. The solution was a sale price of £225 million, payable at closing, plus a potentially large earn-out: a further £55 million if ECP hit certain growth targets for 2012 and 2013.
Both sides wanted Ahluwalia to maintain operational control of ECP so that LKQ could make use of his expertise during the earn-out period. The result: ECP performed terrifically, Ahluwalia met his growth targets, and the earn-out was paid in full in 2014. LKQ was delighted to pay the full £55 million because Ahluwalia had created far more value than that for LKQ shareholders.
In this case, an earn-out helped bridge a valuation gap and create a classic win-win outcome. It worked because the metrics were clear (growth targets), ECP remained a separate business from LKQ during the earn-out period, and Ahluwalia maintained operational control during the earn-out period. As this anecdote illustrates, an earn-out can work to bridge a valuation gap, but only when the circumstances are right.
Academic Editor, Negotiation Briefings
Joseph Flom Professor of Law and Business, Harvard Law School
Douglas Weaver Professor of Business Law, Harvard Business School
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