One of the signs that M&A negotiations have become serious is that price has become a subject of the conversation. It would be very simple if buying (and selling) a company were like buying a carton of milk. The price is determined, you decide to pay or not and take the product home.
But the reality is that determining a fair price for a company, for both sides, is much more complicated than that. Partly because the value of this company to the buyer, well, it depends. It depends on how this company will perform after the acquisition. How many synergies will actually be generated? What costs will actually be reduced? What is the real cross-selling potential?
These issues mean that pricing involves negotiating a mechanism called Earn-Out. That is: a portion of the price that will be paid if the founder/current owners of the business actually earn it. An example: the company is purchased for 50 million, plus up to an additional 20 million if it reaches annual recurring revenue of 10 million in 3 years.
The name is quite literal (about earning) and it often makes sense, as the person who will work to make the earn-out goals happen is one of the partners (often founder) of the business. But since even that “depends”, this is a topic that brings a lot to the table. That's why I decided to make this subject another series of articles, so that we can go deeper without boring you.
Why does Earn Out exist?
Resolving this gap in buyer and seller expectations about what the company is worth is a mission for one of two mechanisms: a crystal ball or an earn-out clause. If it were possible to know the future, it would not be necessary to negotiate any variable value. But in the absence of that possibility, let's agree that it is better to have an additional value, even if it is only if the positive result that everyone hopes for materializes. Let's understand this from the perspective of both parties.
Buyer's perspective
Let's call John, the buyer of your company. He has some expectations. The first is to pay a fair price. If he buys the company and then it dismantles, the guy won't look good in the photo. So, even though that wonderful business case spreadsheet shows a discounted cash flow that indicates that the company is worth 100 magic beans if it continues to grow at the same pace, John will prefer to just pay the 100 beans if it actually grows to that cloud that the Excel sheet shows in the “AK” column.
Furthermore, he typically doesn't wait to take charge to deliver that growth alone. He expects you and at least the key people on your team to be there for it. Therefore, from the buyer's perspective, the earn-out is a tool to cover a valuation gap that will only materialize if some assumptions remain true, but also to keep the team that is capable of making this happen engaged.
Seller's perspective
You know that your company can grow until it reaches the clouds. You know that’s where the “golden goose” is. In fact, the original dream was to continue growing alone to keep the eggs entirely for yourself. But since John is interested in this too, it might make sense to join forces towards the big dream.
But you don't want to sell it for what it's worth today. You want the potential of reaching the clouds to be taken into consideration, right? Well, the buyer may be willing to pay for it, but only if it actually happens. And since you trust it so much that you were doing it without the buyer, you will be willing to accept it. Or won't you?
Golden tip
The energy you put into the earn-out negotiation will communicate a lot about your belief and thirst for the goals being discussed. Here you should be careful with some extremes. If you realize that the goals are too high, considered unachievable, and the seller realizes that you don't believe in the plan, this could put the deal at risk. But this can happen either if you negotiate too hard to reduce targets, or if you give up negotiating and demonstrate that you did it because you don't believe in it.
If you don't negotiate the earn-out because you think it's easy, you may be leaving money on the table, as you could propose higher goals for an additional payment layer.
So the tip is: negotiate for what you believe.
If you feel that the deal is at risk and you depend on it for the company's survival (been there, done that), it's worth accepting impossible goals that you still don't believe in. But if you have alternative buyers, your life will be much better in the coming years if you are working with motivation to deliver a goal you believe in.
Conclusion
Earn-out arises from the natural tension between the value that the seller sees in his business and the guarantees that the buyer seeks before making a full payment. It is not just a question of price, but a tool that serves multiple purposes: valuation gap bridge, talent retention and incentive alignment.
But perhaps the most valuable tip you can take away from this first article is: the energy you dedicate to the earn-out negotiation communicates a lot about your confidence in the future of the business. Don't accept impossible goals just to close a deal, nor stop negotiating more ambitious goals if you really believe in the company's potential.
In Part II of this series, we will dissect the anatomy of an earn-out and understand how different metrics and structures can impact your post-acquisition success. For now, reflect: what level of confidence do you have in the projections being discussed at your negotiating table?