Earnouts

By Tom Taulli

Recently, Micromuse purchased Lumos Technologies. It was a synergistic fit. In all, Micromuse paid $2.7 million in cash and assumed $800,000 in debt. However, the seller would receive only $1 million in cash at the closing. What happened to the remaining $1.7 million? Well, it was reserved in escrow for an earnout.

Earnouts are a common approach to bridge a deal between the skeptical buyer and optimistic seller. Itís really a win-win proposition. The earn-out can mean a windfall for the seller. It can also help maintain key managers on board to help with the transition. It can also help improve overall performance of the combined entity.

But, of course, the devil is in the details. Earnouts can easily turn into a lose-lose proposition if not structured properly.

Here are some strategies to consider:

Earnout Approaches...

? Clear Measures: We have all heard the horror stories of the poor screenwriter who got practically nothing from a blockbuster film because he got the ìgrossî in his contract. Earnouts are, in fact, very similar to Hollywood contracts. In other words, the goals must be very clearly defined. Should earnings be cash earnings or GAAP earnings? It will make a big difference.

? Short-Term Pop: If the goals are mostly short-term in nature, the seller may sacrifice the long-term viability of the company to get a nice payout. Thus, the goals must be tiered along short-term and long-term milestones. To do this, you need to run projections and scenario planning ñ a process that should not be rushed.

? Realism: All goals need to be realistic. This is definitely the case when creating the milestones for an eanrout. Interestingly enough, the seller can be too optimistic when setting the goals.

? Separate But Equal: If a selling company will be completely integrated in the new company, it can be very difficult to measure performance. Is it really the parent company or the seller company or a combination? In this case, it may make sense to develop a short-term earnout that allows for quick integration of the two firms.

? Small Deals: Earnouts seem more appropriate for smaller acquisitions. Why? There are several reasons. First, small companies may be in the start-up phase and it will take time to see if the product is real. Next, buyers do not want the uncertainty of price for a big acquisition. It can allow for unpredictability for Wall Street.

MergerPlace is pleased to have the esteemed Mr. Tom Taulli as the managing editor of our MergerPlace M & A Advisor™ E-zine.

Tom Taulli is an expert in the M&A process. He is the author of the critically acclaimed The Complete M&A Handbook (Random House) as well as six other books written for publishers such as Bloomberg and McGraw-Hill. Tom also teaches M&A at the USC School of Business.

Tom has been quoted extensively in the press, including the Wall Street Journal, USA Today, Barron's, and The Los Angeles Times, and has provided commentary on CNBC, CNN, and Bloomberg TV, as well as appeared on a variety of top radio stations across the country.

Tom's books are available for purchase in our bookstore.

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