Earnouts: Part 4 - Conflicts

Welcome to Part 4 of our series on earnouts.

We've already covered why they are used, how they are structured, and how to negotiate the best terms (see the links below).

Earnouts very often go wrong... A survey of sellers from 2019 showed that:

• only 12% of sellers got paid the maximum amount under their earnout, and
• 62% of sellers felt they have been treated unfairly by their buyer in their earnout.

Those are striking numbers! Earnouts are the most common reason for litigation between buyers and sellers, and the most common source of post-deal regret in sellers.

Here we consider why earnouts go wrong, and how you can avoid getting screwed.

Recap

Here are the previous articles in the series if you want to go back and read them:

👉 Earnouts: Part 1 - Why and when?
Why earnouts are used and when sellers should expect to see one.

👉 Earnouts: Part 2 - Mechanics
The nuts and bolts of how earnouts work and the mechanics of metrics, targets and payments.

👉 Earnouts: Part 3 - Negotiation
How to negotiate the best earnout terms. See also The 10 biggest earnout negotiation mistakes to avoid.

How earnouts turn sour

There are four reasons that earnouts 'turn sour' for sellers.

They each have very different root causes, dynamics and resolutions. Let's explore them in turn.

1) No fault

Your business just doesn't hit the targets in the earnout.

Maybe you didn't execute as planned, or you made a few strategic mistakes along the way. Some key hires didn't work out, or the market softened unexpectedly. Or in hindsight, the assumptions in your forecasts were just too bold.

But nobody is at fault. You don't feel like the buyer unfairly hindered your progress, and they are happy that you stuck to your end of the bargain and tried your best.

Whilst you will be disappointed, this is actually the healthy operation of the earnout – it is doing its job. Remember, the earnout is designed to force the company to prove its value for the seller to get paid in full, and in this case it did not perform as hoped.

Nevertheless, here are some tips that can help:

• In the negotiation, push to avoid an 'all or nothing' earnout, so you will get paid something at least even if the performance is mediocre. That means avoiding a cliff mechanism, and pushing for interim milestone payments. We discuss these in Part 3.
• Try to include protection against external factors beyond the seller’s control. This doesn't cover you for general under-performance, but for 'black swans' – e.g. another Covid-style pandemic shutting down operations for a hospitality business. You might not get it, but it's worth asking. To increase your chances, you should be very specific on which scenarios this would apply to, referring to particular events rather than general market issues. Also discussed in Part 3.
• Lastly, you can always try to renegotiate the terms. It can’t hurt to ask... if you feel that's appropriate in the context of your relationship with the buyer. Maybe they would be happy to keep you motivated with a new deal. That might include extending the time period (to give you longer to hit the same targets), or even lowering the targets themselves. Ask nicely, and you never know!

2) Deliberate seller blocking

This is the other end of the spectrum, and happens very rarely.

The buyer deliberately hurts your business' performance to stop it hitting its targets, to avoid paying you under the earnout. The tactics get really ugly – firing your management, drawing cash from the business, cancelling contracts and so forth.

As owner of the business, they are generally much better off helping the business to grow. Even if that means paying you more in the earnout.

In reality, they are more likely to let the business thrive and use the tactics in section 4 below... hiding behind their lawyers to find technicalities or loopholes to avoid payment without damaging the business.

So this 'blocking' only tends to happen if:

• The buyer has a change in management or strategy which means they no longer see your business in their plans, and they are happy to 'tank' it. If you are profitable and generating cashflow this is less likely (they will be happy to take those profits and cash) but more likely if you are a loss-making strategic acquisition.
• The buyer falls into serious financial difficulty and really cannot afford to pay you, so they have to act drastically to save money. As a side note, if you think this is possible, negotiate for some of the earnout to be put into escrow so it's safe.
• You managed to agree extra generous earnout terms, with aggressive ratchets that reward you exponentially for standout performance (without a cap). Then they later come to regret the deal... Even then, they would usually let the business thrive and find a technicality to avoid payment (see section 4 below).

To protect yourself against these scenarios, you need wide-ranging and robust protections, which specifically lay out the behaviours of the buyer which are forbidden and the consequences of breaching these. More on this below.

3) Seller hinderance

This is somewhere in between.

The buyer is not outright blocking you, but there's enough friction to hinder you from hitting your targets and getting paid as you think you should.

Here's the tension: you want control over how the business is run and managed with freedom to set the strategy, allocate capital and choose who to hire.

But the buyer is now the owner of the business, has already paid a lot of money to buy it, and needs you to fit into the wider strategy, processes and structure of their group. They are your shareholder and do ultimately have control over the business and over you – you'll report to the regional MD, who is now your boss.

Often both parties think they are in the right. This is really nuanced and subjective, and the source of a lot of litigation!

This comes about in many subtle ways, so let's dive into some examples to bring this to life.

👉 Not delivering on promises

This is the most explicit within this category.

Through your conversations with the buyer, they might have made promises about synergies and how they would support your growth during the earnout. That might be: co-selling to their customer base, bundling or co-branding of products, access to their tech or IP, support from their marketing team...

You're excited by this, and agree earnout targets on the basis of this support.

Then they don't deliver. This is rarely deliberate, but their teams are busy and focused on other priorities so they just never get around to it. And remember, a Sales Director at the buyer cares only about their own P&L, not yours.

👉 Strategic misalignment

The buyer interferes to adjust your strategy, so it aligns more with their wider group's goals.

Here's an example: You want to launch in a new market, or launch a second product. You discussed this during the deal, and these revenue lines power the growth in your forecasts.

But they want you to double down on your existing market, as your product is helpful in helping them to reduce churn in their core business. And as shareholder of the business, they direct you to follow that path.

That's a sensible strategy for the buyer's group as a whole, but not optimal for the P&L which is the yardstick for your earnout.

👉 Withholding funding

If you need additional working capital for growth, you are reliant on the buyer to pass that down the corporate structure to you. You can't get external loans or raise capital without their permission.

And then they don't provide the captial, or not quickly enough. Again, this is rarely malicious but their plans or priorities may have changed since this was discussed, and they feel the cash is needed elsewhere. You're then starved of capital and can't hit your targets.

👉 Control over operations

The buyer gets too involved in the day-to-day running of the business, and you feel that it's involvement hampers you from growing the business.

This often manifests as bureaucracy (from within a large corporate). You might get drowned in requests from the finance team for detailed annual budgets. Or your product team is used to shipping product updates quickly, but the buyer insists you have to go through a central security review process with a three month backlog.

These are small issues, but in aggregate they can slow you down enough that you feel blocked from hitting your earnout targets.

So, how can you overcome these issues?

Firstly, you should try resolve the issues amicably before any lawyers get involved. As soon as you feel frustrated, open the conversation. Ideally with a senior contact at the buyer with leverage to make changes.

That might feel confrontational, but remember that you and the buyer are on the same team. Everyone wants the business to grow.

Often, the blockers are just over-zealous middle managers in the buyer's group (who are not allocating you working capital, or being too strict with their tech security reviews). With some guidance from above, your issues could be solved surprisingly quickly.

You most powerful lever here is your critical role in the management of the business. Remind them that if you don't feel like you're getting a fair shot at the earnout, you will lose motivation and the business will suffer.

If that doesn't work, you will need to fall back on the terms of the sale contract. These are Seller Protections, which can be some of the most critical clauses in the contract.

These spell out the specific actions your buyer must take to support you during the earnout period, and the actions which they are forbidden from taking. They should be detailed and comprehensive, often in their own schedule.

An example is: "... the Buyer shall not seek to transfer or divert any existing or potential customers of the Company to any other member of the Buyer's Group."

Here are some tips on negotiating your Seller Protections:

• If you need specific support from the buyer, make sure their requirements are clearly and specifically laid out. You want amounts, dates and action items.
• Your lawyer will add a wide range of generic clauses about 'not interfering with the business'. These are catch-alls, but they vague and it's hard to prove a breach. Push for a longer list of specific prohibited actions that are well defined and easy to prove.
• These clauses are often 'toothless' if the contract doesn't specify consequences for the buyer's breaches. You have to sue them for breach of contract, which means you have to prove the amount of the loss. That's hard to do, and the lawyers' fees are killer. So push for the contract to lay out specific consequences for a buyer's breach, such as automatically paying out the earnout for serious breaches.
• In return, the buyer will demand the right to step in to take control of the business. That's reasonable. But try to limit that to specific and well-defined circumstances.

4) Legal disputes

Lastly, the buyer might use their lawyers to exploit ambiguity in the contract to their favour. They are trying to get both great financial performance in the business whilst avoiding having to make a large earnout payment.

It's sneaky, but it happens a lot.

The most common strategies are:

• Manipulating the definition of EBITDA to include or exclude certain items in their favour.
• Claiming that certain revenues (especially from co-selling or bundling products with others from the buyer's group) should be excluded.
• Burdening your P&L with additional central costs (such as finance, insurance and HR costs) that haven't been previously agreed.
• Using different accounting practices to manipulate the metrics, such changing depreciation rules to reduce net profits.
• And in the most extreme scenario, claiming that you have breached your employment contract so you are terminated as a bad leaver before the earnout period is over, which might invalidate your right to be paid.

How can you stop this from happening? This is where a good lawyer who has experienced these tactics before is extremely valuable. They will help you to put in place protections such as:

• Clear rules around which accounting standards are to be used
• Details on how certain revenues and central costs will be treated
• Right to take any disagreement to an independent third party auditor for review, who has the right to determine the fair amount for payment
• Interest for delayed payments in the case of disputes
• Tight employment contracts with very narrow termination rights

This is another reason why multiple milestone payments are preferable to a single payment at the end of the earnout. If the buyer pulls these stunts on the first payment, there is less at stake and you still have lots of leverage to push back.

Conclusion

Earnouts can be a fantastic way for sellers to get exposure to the future growth of the business. But they come with a tonne of risk, and there are many ways that they go wrong. Armed with the knowledge about how and why, hopefully you can negotiate an earnout structure and terms that give you that upside, whilst managing the risks.