The Art of Drafting Milestones for an Earnout

It is always sad to see former stockholders denied claims they are entitled to be paid in milestone payments under a merger agreement. In my opinion, I believe most buyers prefer to pay earned milestone payments, in particular, if the former stockholders are now employees. Hiring an expert can help facilitate fair terms and can save time and money. Remember, value is always in the eyes of the beholder.

The valuation gap debate

Earn-outs are generally used as a tool to bridge a valuation gap. A valuation gap is a difference between the actual market value of a company and the value the owner expects to sell it for. For this reason, there are often dozens of negotiations required to make this gap as small as possible. Forecasts are often slightly inflated and an earn-out is therefore generally a fair compromise. With that said, valuation gaps remain one of the most common reasons that many mid-market transactions fail to close.

Milestone cat and mouse

In order for the deal to succeed, buyers will often propose future payments based on successfully achieving milestones built into forecasts. The seller will then generally seek clarity on the definition of success to ensure that the milestones are reasonable and achievable. This back and forth can go on for months. Occasionally buyers will need to deploy additional capital for investments to achieve the projected numbers. The necessity to make further investments can expose the buyer to additional risk. The milestone payments can be a strategy to recoup some of the investment capital if the seller was overly bullish when presenting projections to the buyer.

The drafting process

Once general terms are negotiated, the actual drafting takes place and this is where lawyers and M&A experts will get involved. Milestones are generally highly specific and based on multiple factors. Below we provide some general rules you should follow when drafting milestones.

1) Make your expectations realistic

This ultimately comes down to the valuation gap. As the business owner, you should step back and ask if your expectations are reasonable or too aggressive. If you set aggressive milestones, you are opening yourself up to increased risk and setting yourself up for the potential of failure. Both parties will need to negotiate, and often met in the middle.

The majority of M&A deals fall short of the set expectations. This doesn’t necessarily mean the deals are failures. Projecting future earnings and business metrics is not an easy task. Solid and realistic expectations for the earn-out will prepare you well for the negotiations.

2) Keep it Simple

The simplest earn-out is none at all. Additional cash is great, but this could come in the way of a salary for 3-5 years vs. setting earn-out goals. Like any deal, there is a substantial risk of failure and these risks may involve factors outside of your control. I have seen earn-out deals with an extremely complicated matrix of variables and goals. Fair to say, I normally see the founder’s equity/cash pulled back by the buyer. A buyer who has set out a complicated set of goals that span earnings, customer retention and sales should be challenged.

3) Avoid Common Pitfalls

Although the goal is to keep the earn-out structure as simple as possible (or avoid one altogether) you might still be interested in having something in place. If you believe wholeheartedly in your company’s potential, and want to continue to guide its success, an earn-out can give you the opportunity to do so. However, we suggest thinking about the following things before you accept this new challenge.

  • Keep your key players. You know the key people in your company. Be careful if you don’t have these players behind you post-acquisition. You do not want to start building a team from scratch during your earn-out period.
  • Keep the length of your contract as short as possible. An earn-out might sound like a good idea but avoid long contract terms. This will minimize “burn-out” risk.
  • Make sure you have control. Make sure you are only accountable for what you can control. If the buyer shuts down a division you need to operate, this could eliminate your pay-out or force a clawback.
  • Ensure that incentives are in place. If you’ve made a lot of cash in the initial sale, it’s natural to lose enthusiasm for the future goals of the company. Structure the earn-out in a way that you know will keep you motivated. As mentioned above, a short contract term helps with this.

4) Aid Wins, Avoid Losses

Talking and discussing the multiple outcomes with the buyer in advance helps. But remember, they will never make it easy. You will need to have a simple, clear-cut plan and procedure for earn-out to pay-out. Here are some questions you should ask.

  • Will you have autonomy? The best earn-out outcomes are generally when the seller is allowed to continue running the company as they did prior to the acquisition. If this is not possible then consider including some clawback terms in the agreement to protect yourself.
  • What is the purpose of the earn-out…financial or strategic? It is hard to get a clear answer here. In fact, this can be where the trust breaks down between the buyer and seller. An earn-out made for financial reasons is generally when the buyer has faith that the owner can expand the business and achieve the projected results. Rule of thumb: if the acquirer keeps a respectful distance and seems to be giving you autonomy, this is a good sign. A strategic earn-out is where the buyer wants you to fail. Of course, they will not tell you this, but warning signs here are micro-management and a confusing matrix of metrics you need to hit.
  • How will the earn-outs goals be evaluated, and by who? It sounds simple, but murky terms can lead to debate down the line. Ask up front who will be evaluating the earn-out metrics under new ownership, and when these evaluations will take place. Although there’s no right answer, these questions should be addressed early on in your negotiations.
  • How will outside events impact success? There are dozens of factors in business that neither party can control. This can, however, impact the ability for you to maximize the rewards pledged in the earn-out. These can be anything from an economic downturn to a natural disaster. Make sure to create contingency plans to address the most unlikely of scenarios – especially if you’re entering into a long-term earn-out deal.

Selling your business can be an exciting, once-in-a-lifetime event for many people. Ensuring that you have a well-structured earn-out can help ensure that this major decision is not one that you live to regret.

Corbin Bridge on Linkedin
Corbin Bridge
Corbin Bridge is a licensed investment banker at InvestmentBank.com. He has prior experience assisting private companies in developing and executing acquisition strategies. Corbin works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. His areas of interest include Blockchain, AdTech, and Entertainment. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Corbin resides in Las Vegas, Nevada.
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