I talked to one of my friends in M&A @ one of the top tech companies the other day. I was surprised to hear that their target is a 55% success rate for companies they acquire. They want it to be slightly better than a coin toss, but not so high that they over-think any deals. Their logic is that it's okay to have 50 failed deals, as long as they're the guys who find the next YouTube/Hotmail/PayPal.
That's interesting. I bet that companies require acquihires to have a higher percentage of success (where I presume success here means the team staying, since the product is often shut down in acquihires). I wonder what M&A people would think would be a good percentage for acquihires.
There was a post/link I read here recently that discussed the earn-out issue in depth and it's really colored my thinking on it (BTW - if someone can remind me whose post it was or point me in the right direction, that'd be hugely appreciated). I think they nailed it.
Basically the idea was this: When you sell your business, you should be paid -- in cash -- for the value you've created. That's what a sale is, and that's what a sale should be.
An earn-out represents value that is yet to be created -- the future interaction between your business and the acquirer's business. There's nothing wrong with that inherently, but recognize that it's really just an incentive for what is to come, not payment for what was done.
Now, none of this is saying that you shouldn't accept a deal with an earn-out if that's what you've got in front of you. But you have to think about it differently --
If you built a business that you think is worth $100M and you sell it to BigCo for $100M, 50% of which is structured as an earn-out given revenue targets over 3 years - guess what....you didn't actually sell your business for $100M.
You sold your business for $50M and agreed to a $50M compensation package in your new job. And with that new job comes the uncertainty of what your new owners will do. They could, conceivably, decide to close your division and lay everyone off after 6 months - having absolutely nothing to do with you or your team (this happens in big companies).
So when the time comes, just make sure you have the right perspective about what price you're actually selling your company for.
The other issue with the earn out, from the entrepreneur's point of view, is that you're providing the acquirer with effectively interest free financing for the earn out, while you're working on integrating. And there's nothing guaranteed in the earn out, and they're usually all-or-nothing structures (ie, get $0 if you hit 99% of target)
Why would a business owner agree to an earn-out? That's like handing someone your equity and trying to earn it back from them over three years. I assume this is for acquisitions of unprofitable companies, otherwise traditional valuation methods could be used to determine the price. Buyer beware is a lot better system.
Beacause it takes risk away from the purchaser, making it (hypothetically) an easier sale and worth more money. Mergers are extremely susceptible in the first 12-24 months and can actually take down the parent company if mishandled.
Yeah, but if they are told to meet a specific EBITDA, and the parent is charging expenses to the company, it would be in their interest to charge enough that the earn-out doesn't pay. If the parent gets to write checks with the company's money, then the earn-out goals should be on gross revenue.
Usually the idea is to create a much bigger business by partnering up with a large company with a lot of resources. The buyer may offer access to a larger market, expose your company to more to customers and so on.
I'd love to have to deal with some of the earn-out problems discussed in this article... The part about corporate overhead was especially insightful to me, a good watch out. Thanks for posting.
