Earnouts – the Pros & Cons

The performance of companies in the Recruitment Industry is often only as good as the people within them. Systems, processes and technology all play an important part in determining productivity and competitive advantage, but if you lose your best performers you may very well lose big parts of your business.

Intangible factors like this are one of the reasons that many acquiring companies prefer to have performance criteria for the vendor linked to final payments. The unpredictable nature of future profits makes an earnout an often favoured model in the industry.

What is an Earnout?

An earnout refers to the linking of the acquisition price to the future performance of the acquired company. This is typically over future periods of between six months and two years. The proportion of the total price that is attributed toward the earnout component is determined by the negotiation process; however, it is often up to 50% or more of the final value.

Vendors selling their business may display unbridled optimism about just how well they are going to do next year, but that optimism may not always be enough to convince a buyer. Putting in place a performance based earnout model allows a buyer to bridge the gap between the vendor's projections and their own.

So earnouts sound like good sense, and often they are, however, if not designed and managed properly they can cause problems.

Measuring Performance

Having the seller and the buyer agree on an earnout value and the performance targets can be a lengthy process. Both parties aim to reduce risk and increase the benefits to their side of the negotiation. As a result, some earnout structures and targets can become complex and ultimately prove difficult to monitor.

Acquiring companies may want to tie the final sale value to a future profit result. However, this isn't always so easy. If for example a company exclusively operating in the Melbourne business support sector buys a business recruiting in ICT in Sydney then there can be a relatively easy measurement of profitability over the course of a year. However, if the company being acquired is in the same city or region, has some overlap of clients, offers similar recruitment services (even in part) and is competing at times for similar candidates then it can be very much harder to isolate and agree the results.

The two companies may find themselves competing actively with each other for the sake of preserving an earnout model.

Inevitably, even in the first example, the acquiring business will impact on the management of the target business. Owners and executives will move to integrate the businesses for longer term benefit while the vendors will want to maintain their control to maximise their earnout value.

Related: Starting your own Recruitment Business

Failure to agree on the extent of control held by both parties during an earnout period has led unfortunately to resolution in the courts.

Conflicting Priorities

For a company spending substantial amounts of money to buy another company there are lots of very good reasons why you will want to integrate the business as smoothly and as quickly as possible. To achieve cost savings and greater combined sales and marketing efforts then the sooner that you integrate the sooner you will start to gain return on your investment.

From the vendors point of view during an earnout period that may be well and good, but they may have a profit target that is at the top of their priorities and will want to control events in order to achieve it. In this circumstance the vendor may become highly focused on short term profitability at the expense of longer term opportunities. Long term strategy may not apply any more.

For the buyer this might leave them with a business in a lessened state than before the transaction.

If one or more of the vendors / managers leaves the business before the end of the earnout period then an acquirer may well be reticent to pay an earnout (in full or part) in those circumstances. On the other hand the vendors may be wary that if an earnout is reduced or not payable in those instances they may be deliberately forced out by the acquirer to avoid payment.

All of these uncertainties and potential areas for conflict does not mean that earnouts have no place in successful merger and acquisitions. However, it is important for both parties transaction to think through the potential consequences of a deal structure, have sound professional advice and focus on what outcome they want from the transaction.

Other Performance Measures

In recent years in a wide range of industries, earnout models are being calculated on factors other than profit. It is not a given that the only criteria is the profit figure. Other Key Performance Indicators can be used that help both parties achieve their goals.

These may be factors such as:

• Key client retention
• Staff retention
• New business brought in
• Development of a particular market segment
• Staff development

There may be many other measures that apply to the specific circumstances of an acquisition that provide alternatives when measuring profit may become complex.

It is likely that with the nature of the Recruitment Industry that earnout structures will always be a part of the pricing model. Used appropriately they can work well and equitably for all parties.

Originally published in Recruitment Extra Magazine August 2005.