The Case of the Elusive Earnout

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HEIDI: Welcome to The Startup Solution and "The Case of the Elusive Earnout." I’m Heidi Roizen from Threshold Ventures.

There seems to be a heating up of M&A activity right now, which is generally a good thing for entrepreneurs. One of those entrepreneurs, who I’ll call Celia, was in the midst of her own M&A negotiations a few weeks ago – and when she and her prospective buyer hit an impasse on valuation, she called me for some advice.

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CELIA: Hey, Heidi, it’s Celia. So, things are moving forward on the deal, but the buyer and I keep going round and round on the acquisition price. They say they are only willing to pay $40 million, but I’m trying to stick firm to $50. Anyway, today, they proposed that they could put the $10 million difference in an earnout, which sounds like it could be the way to get this done. Do you have any experience with earnouts, and if so, can you tell me what I should include in mine? Thanks.

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HEIDI: It's fair to say that almost no entrepreneur gets exactly the price they want for their startup. And often, when they hit that impasse between what they think it’s worth and what the buyer thinks it's worth, it's almost inevitable that someone will suggest an earnout.

So today, I’m going to fill you and Celia in on what to know about earnouts, and what to include in yours to give yourself the best chance of ever seeing any of it. I’m doing this because sometimes acquisitions won’t get done without earnouts, so I want you to be prepared. But I’ll warn you that I pretty much hate earnouts and I try to avoid them – and you’ll understand why as we dive in.

Let’s start with the easy part – what is an earnout and when does it come into play?

An earnout is a provision in a merger or acquisition agreement that provides potential future payments to the sellers of the business based on the future performance of the business they sold.

There are two main reasons earnouts get proposed in acquisitions. I’m going to start with the less common one to get it out of the way up front. In certain cases, the buyer proposes an earnout to incentivize the founders and employees to stay with the company and perform. This might make sense if the company being acquired is a sole proprietorship or an employee-owned company, that is, places where the team also makes up the bulk of the shareholders. But in a venture-backed company, there are almost always a bunch of shareholders who are not employees – like former employees, founders who have left, and most of all, all those venture investors. And all of them will have zero impact on the company once it’s sold. So, an earnout in those cases won’t motivate them to do anything except maybe hope and pray that all goes well.

The better way to incentivize employees coming with the deal is to pay them directly.
You could use retention payments, which are simply payments for remaining with the company for some period of time, or through performance bonuses, which are generally the same as existing employee performance bonuses.

In my experience, retention payments and performance bonuses are pretty common for key employees. But that’s not technically an earnout, which, remember, is a payment to shareholders for subsequent company performance.

. . .

There’s one other typical payout to shareholders in an acquisition that you should be aware of; that is also not an earnout. In many M&A deals, a portion of the agreed sale proceeds, say five or 10%, is held back for some period of time, usually six months to a year, to ensure that there is a pool of cash available for negative information that may pop up after the deal closes – like bad receivables, or taxes, or other liabilities that were unknown at the time of close. And if nothing pops up in the agreed-upon time period, the money is released to the shareholders.

In my experience, the money is almost always held in escrow and managed by a third party, and these types of holdbacks are almost always paid out. However, sometimes the holdback money is held by the buyer, which may give the buyer extra leverage when it comes to not paying it out – so I recommend that if you’re subject to a holdback, you should insist on that money being held by a third party, not by the buyer.

So now that I’ve explained all this, let’s set bonuses and holdbacks aside and focus on actual earnouts.

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The main reason earnouts come into play is because the buyer and seller can’t agree on a price. The seller believes their company is worth a lot, at least in part, because it has a bright future ahead of it. The buyer is not so sure that this bright future will actually happen and doesn’t want to bake that upside into the price they have to pay right now. So, the two sides negotiate to put in a provision that pays out that difference in value based on the performance of the company after it’s been acquired. You know, hit the revenues you said you would, and you get the higher price. Easy-peasy, right?

Actually, not so much.

I’m going to give you an idea of how difficult earnouts are to actually get by using recent market data from a company called SRS Acquiom. SRS Acquiom is the big Kahuna in the M&A deal management space. They’ve managed over $90 billion worth of earnout potential across 1.5 trillion dollars in aggregate upfront deal value. So yeah, they know the real story when it comes to earnouts.

They're generous about sharing the information, too, through their annual M&A claims insights report – which I’ve put a link to in the show notes. The data in their 2024 report covers over 850 private company acquisitions valued collectively at $168 billion, for which they were the stockholder representative.

And here’s the bottom line about all those earnouts – only 21% of the total dollars that all those earnouts represented were actually collected.

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But wait, it gets worse. Because of the $775 million gotten in those actual payouts, $132 million was paid as the result of renegotiations – that is, paid only after they were contested.

And underneath that 21% average is an even more telling statistic: of all the deals with earnouts, only 59% of them ever received any payment at all. So that means that four out of every ten earnouts got exactly zero. The smaller deals do even more poorly – for acquisitions having $50 million or less in upfront value, less than half with earnouts see anything paid at all, and the median payment for those who do see anything is only 43 cents on the dollar, instead of 67 cents on the dollar for deals over $50 million in value.

So, there you have my main point of this entire episode: if you have an earnout in your deal, it would be best for your sanity to set your expectations that it will be worth nothing – because that’s a pretty likely outcome.

OK, now that we got that out of the way, I expect some of you will still want or need to include an earnout to get the deal done. So let me give you some gotchas to look out for and some potential ways to circumvent them.

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Again, earnouts are paid to the prior shareholders of the acquired company and are earned by continued performance of that acquired company. And as you can imagine, the mechanics behind that can be quite complicated and convoluted.

Remember, once your company is acquired, you’ll no longer be in control of what happens to it. You won’t control the budget it gets or the additional resources that may or may not be applied to helping it achieve its greatness. And the buyer may promise future resources that they ultimately don’t deliver on. You won’t control where your company falls in the stack of priorities your buyer has. And regardless of where it is when they buy it, their priorities might change. Or their budget might change. Or their leadership might change.

I was in a situation like this where the acquisition was led by a real visionary inside a large company, but after the acquisition, he was pushed out in a management shakeup. The new CEO didn’t see any value in our company given the strategy he wanted to pursue, and took resources away from our now-internal division to put elsewhere – totally his prerogative but not so good for our employees or our products. Luckily, in this case, we didn’t have an earnout, so we weren’t impacted financially. But it still sucked, at least emotionally, for all of us who were still working there.

Even when an acquisition becomes more central to the buyer’s strategy, that doesn’t guarantee that your former company’s revenues will earn that earnout. In fact, most smaller acquisitions aren’t run as independent companies but instead are integrated into the larger company. I mean, that’s often the point of doing the acquisition: to integrate both the people and the technologies into the acquirer’s product lines. And even a good integration can lead to problems in an earnout. For example, what if your product is discontinued, but features and technology from it get baked into the acquirer’s product? How does that revenue get counted towards your earnout, if at all?

Even if your product is maintained as a standalone, it will likely be incorporated into the parent company in other ways. It may now be sold by the acquirer’s sales force and supported by their tech support –and that transition will take resources and time. And often by time, I mean your time because you will have to train all those people.

Even if the performance targets seem clearly defined, it may be unclear as to how they are actually accounted for. And as any Hollywood accountant can tell you, profitability is a number that can be altered depending on what you throw into the expense line. Your acquirer may have a different method for revenue recognition, allocation of costs, or how shared expenses are actually shared. If you’ve never heard of “transfer pricing” and you’re doing an earnout, now would be a good time to learn what that means – and I’ve put a link to a good explanation in the show notes.

In one case I know of, the entrepreneur told me that his acquirer had an eight-figure cloud budget that they wanted to share evenly across all their business units for simplicity’s sake. Uh yeah, that may be simple, but that allocation would have been five times what the acquired company had actually been spending for their cloud services. In the end, this entrepreneur convinced the acquirer to track it separately, but it almost ended up tanking the deal.

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Of course, it’s not only the internal stuff that can get you. Economic downturns, new competitors, or other negative winds can impact your former company and its new owner. A downward shift in the macroeconomics can not only weigh on your former startup’s sales, it will likely also hit the parent company and their other products as well. And that change might force them to recut their budget and, well, those budget cuts might include your former baby.

Remember when I talked about those retention bonuses? Well, while they’re not part of the earnout equation per se, they do influence something that may be important to actually earning the earnout – and that is the people. Your fantastic, essential employees may not choose to stay even with those retention bonuses. They may not like their roles or their boss, or well, pretty much anything, and choose to leave. And this may, in turn, lead to product delays, customer decommits, or all the other things that happen when key employees leave. And that will likely mean more bad news when it comes to your earnout.

I’m guessing that you’re starting to understand why I hate earnouts so much. But if you’ve still got to do one, here are some things I’d suggest you do to give yourself the highest chance of it amounting to something.

Before you even start, get good counsel. You’ve probably never been through an acquisition before, but your buyer has probably done some or even many of them. You need to even that playing field by having experts on your side as well.

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Then to mitigate the chance that all the bad stuff I just talked about will hurt your earnout, here are some good points to clarify right up front in your earnout agreement.

First, make sure that every performance metric is very clearly specified. Go into detail about how it’s calculated, including clarifying any nebulous terms, such as whether it’s based on gross or net numbers and what specific expenses can be netted out. For example, one entrepreneur told me that in his deal documents, revenue was defined as “cash actually received,” which is definitely not how it’s defined in standard accounting terms. The point is, if you’re going to have metrics, make it crystal clear how those metrics are calculated.

Next, specify the resource commitment that the buyer will provide to help your former company achieve its glory. This could be in sheer dollars or even more specifics such as precise size of additional sales team, minimum allocation of engineers, or guaranteed marketing budget.

Then, you should focus on internal accounting stuff like transfer pricing. It should be very clear to you upfront what corporate overhead burden your former startup is going to bear, what kind of shared internal services you’ll be required to pay for, and any other “taxes” to your profitability that weren’t part of your equation before you were inside a bigger company.

I know of one case where an entrepreneur and her team were really excited to learn about all the additional benefits their acquirer provided employees, including 30% bigger pay packages for everyone. But of course, after the deal closed, she came to realize that all the extra money those cost – plus a 10% ‘transfer price markup’ – would be coming out of the expense side of her earnout equation.

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As for those earnout payments themselves, you might want to have them be more granular, so it isn’t all or nothing. For example, if you only hit 80% of the target, will the resulting earnout be zero, or 50%, or also 80%? I mean, it would be nice to be paid if your business performs well, even if it doesn’t perform quite as well as anyone hoped. But I’ve seen a number of earnouts with very high hurdle rates, below which you get nothing – and trust me, getting nothing for that still-good performance is a real downer.

In the story I told earlier about my first situation, none of us could have predicted the management shakeup and the resulting priority change it caused. But in my experience since then, this happens more often than you’d think. So, this is another potentiality to build into your earnout right up front by including acceleration clauses on the payouts if your former company is shut down, reorganized out, or even sold during the earnout period.

Another best practice is to include “good faith” clauses, basically saying that the acquirer should make a good effort to achieve the earnout. In fact, according to SRS Acquiom, 90% of the deals they do include language along the lines of, “buyer shall take no action the primary purpose of which is to thwart the earnout.” You can also try to further nail this down with specific definitions of what is commercially reasonable for the buyer to do. You’re certainly not going to get those formal commitments from the buyer after they’ve bought your company, so the time to ask for all this is before your deal closes.

And when it comes to negotiating your information rights, it’s good not to be kept in the dark about how the company is performing all along the way before your payout is due. Nothing is worse than sellers who think that the earnout is a slam dunk, only to get a letter two years after the fact saying that, surprise, they’re getting nothing. Ideally, you want the buyer to be required to keep you updated on a regular basis about how the performance relative to the earnout is going, with adequate detail for everyone to fully understand the situation.

. . .

I want to get back to Celia, remember her? She’s the entrepreneur who originally called me about her earnout negotiations. When she first called me, I walked her through all the stuff I just told you. But a few days ago, she called me again because she knew I was working on this episode, and she wanted me to pass along some additional things that she had learned through her process.

Celia said she’d found the earnout really challenging to nail down, not only because it was complicated but because the earnout had to be negotiated at the same time that a whole bunch of other things were being negotiated, and she hadn’t been prepared for how complicated and interconnected all those things were going to be.

Then she said she’d felt so relieved when she had a handshake on the deal, only to realize that then she had to start another huge task. Because while Celia may have been the chief negotiator, she’s not the sole decision maker. So, she had to get her board to agree to the deal. And she had to also get her key employees to buy in, many of whom were shareholders entitled to some of those earnout proceeds.

And then, even with the board and the employees backing the deal, she still had to get a majority shareholder vote. Celia told me that it had taken a ton of her time to reach out to investors, which almost put the deal at risk as the approvals dragged out. And for all that time she was working on approvals, she wasn’t getting any of her regular work done. Celia felt that even this was already creating headwinds for earning the earnout she negotiated so hard to get. So, Celia asked me to underscore for all of you that even if you negotiate an earnout you can live with, you still have a long way to go to get the deal done.

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I have one last piece of advice of my own about earnouts – and, frankly, about selling your company in general. And that is, as Elsa in Frozen says, “Let it go.” This is so hard. Your company was your baby. You hired every person. You carried the burdens and high-fived the victories. You’ll inevitably still feel a lot of ownership over it even after you’ve sold it – especially if you end up working for the acquirer. But the truth is, it’s not your baby anymore, and you need to learn to let it go.

This is the psychological reason that I don’t like earnouts because they force you to focus on things that used to be in your control but aren’t any longer. I didn’t even have an earnout in my own acquisition, and it still took me a long and painful time to make peace with the fact that I no longer had control. So, trust me – the sooner you get your head around that, the happier you’ll be, earnout or not.

And that concludes this episode of The Startup Solution. I want to thank SRS Acquiom for its data, and especially Kip Wallen, who leads the thought leadership practice and helped me get the details right in this episode. Thanks for listening, and if you enjoyed the show, please pass it along to someone else who could use it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

I went to the source of knowledge for this topic, Kip Wallen at SRS Acquiom, who suggested the following:

Here is their M&A Claims Insights Report, which is where I got a lot of the data for this episode.  

This article provides more color and things to watch for in earnouts.

And here is a deep dive on how to structure earnouts.

And one from me, for those of you who want to geek out on accounting. It’s all about transfer pricing.

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