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Caution: Earnouts Ahead

Tying price to performance can be a good way to acquire hard-to-value companies -- if you're careful.

3Jun

You've valued your target fairly, and your acquisition is almost complete. But you still don't buy the sellers' unbridled optimism about their own prospects. If you're like some acquirers, you might design an earnout -- a performance-based component of the final price -- to bridge the gap between your projections and theirs.

Besides allowing both parties to "agree to disagree" on elements of the valuation, such contingency terms usually create incentives for managers to stay on and work hard after the acquisition. Earnouts also spread the risk in a deal. Robert Bruner, a finance professor at the University of Virginia's Darden School of Business Administration, explains that they function very much like a call option, "letting the buyer commit a little money, and then wait and see what the outcome is."

Most experts believe earnouts have a useful place in the mergers-and-acquisitions toolbox, if perhaps limited to certain types of smaller, nonpublic deals. Be careful, though. CFOs who have used them warn they can be dangerous if handled improperly.

Contingency terms are found in 4 percent of all announced U.S. deals -- closer to 10 percent of deals valued at or below $250 million. More than 200 acquisitions have contained earnouts in each of the past five years, with the total value of the transactions peaking at $27.9 billion in 2000.

Professor Bruner suggests that their increased use of late reflects the rise of intangible assets in M&A valuations, and the need for seller and buyer to work out the pricing disagreements that intangibles can cause. Earnouts are most often considered "in the case of young companies, unproven new technologies, unmarketed artistic or creative assets, major new products or geographic markets -- anywhere there is a great deal of uncertainty about the future," says Bruner. And they are sometimes the sole basis of payment for distressed properties.

Among the current crop of earnout deals is E-Trade Group's purchase of online trading platform Tradescape Corp. for $100 million of E-Trade stock, a price that could grow to include shares worth another $180 million. "If we have to pay out that extra amount, we will be very happy," says E-Trade CFO Len Purkis, noting that Tradescape must reach both "aggressive earnings targets and revenue goals" for that to happen. Tradescape's owner-managers, of course, would cheer also, since they would earn the big contingency payment.

Earnout Burnout

So what are the hazards? For one thing, if poorly structured, earnouts can lead to opportunistic behavior by the seller-managers as they try to trigger their hefty payouts. It's "poison to structure an earnout for only a short period of time," notes Bruner, citing a term of one year or less as a common cause of trouble.

Baltimore-based Sylvan Learning Systems Inc. certainly found it so. The company, a prolific acquirer of educational companies in recent years, started out by setting up one-year earnouts. For the managers Sylvan retained, "the natural response was to go gangbusters in terms of revenues, and not spend for future growth," says senior vice president and CFO Sean Creamer. Sylvan now designs earnouts for three years or more, and monitors the deals carefully, sometimes using special audits to make sure the managers aren't "gaming the system."

Picking the right determinants of performance is also tricky. Some CFOs warn against using earnouts when the target is going to be quickly and completely integrated into the acquirer. That's because the performance of the acquired business itself--the fairer standard in determining most payments--is hard to gauge unless the operations are kept somewhat separate for a time. E-Trade's Purkis, who once managed earnout acquisitions in Europe for General Electric's lighting and plastics businesses, says the Tradescape deal was designed to be "clean and simple," and easily measured by Tradescape's stand-alone performance in the first 18 months after the acquisition.

Purkis warns that "if earnouts are not structured right, they can be totally demotivating." In some cases, CFOs shun revenues as a measure, preferring cash flow, or even such nonfinancial terms as new accounts created. Still, whatever the final terms, "the key to an earnout, quite honestly, is defining it," says Purkis. It shouldn't be "too burdensome" for either side. "But you also need it to provide a real challenge" for the managers staying on with the target.

Brooktrout Inc., a provider of telecommunications hardware and software, tried earnouts in an acquisition in the early 1990s, and discovered that a demotivated workforce can destroy all the supposed benefits of the approach. In its case, says CEO Eric Giler, Brooktrout agreed to assume the liabilities of a Texas company, and to make contingency payments to the selling executives if they hit certain sales goals they set for themselves.

"Entrepreneurs are their own worst enemies," often setting targets that are too ambitious, says Giler. And they did that here, falling far short of the earnout goals. While conventional wisdom may say that this would be good because Brooktrout wouldn't have to pay the earnout amounts, Giler soon learned otherwise. "As you start to miss your targets, the incentive goes way down, and you have to fix that" so the employees will stay committed, he says. In Brooktrout's case, that meant "resweetening the deal" with a whole new set of stock options and cash bonuses for the very employees who had failed to achieve their original goals.

"The Complexity Discount"

If earnouts are used in a deal that's too large or high-profile--and especially if two public entities are involved--the problems can multiply. "Earnouts signal the presence of high uncertainty," says Bruner, noting that investors often blanch at M&A contingencies. "Quite often CEOs and CFOs don't want to tell the world about a difference of opinion," but an earnout does just that.

"You don't know what the ultimate purchase price is going to be, so it's more manageable when they are smaller deals," says Sylvan's Creamer, who has been involved with weaving contingency elements into several acquisitions. After its faltering early experiments with M&A earnouts, Sylvan modified its approach and has since used it in a half-dozen smaller deals, generally ranging from $5 million to $100 million.

In one bigger deal it counts as a success, Sylvan acquired Drake Prometric LP in 1995. The Bloomington, Minnesota-based provider of assessment testing programs received $20 million in cash and 5.9 million restricted Sylvan common shares worth another $49.5 million. Sylvan put 2.7 million more shares in escrow, valued at the time at $9 million, to be released in proportional amounts to the sellers if various revenue goals of the testing business were met through 1998. Up to another $40 million of cash and stock contingency payments, as then-valued, could be made if other revenue targets were hit over the next two years. (In this case, the sellers did not stay on as managers of their old business.)

Because Sylvan's share price rose, the actual value of the payout to the sellers soared past the deal's original $118.5 million maximum valuation--to $141.2 million. Creamer says that by taking stock, the sellers showed "confidence in Sylvan's management team."

In an interesting footnote, Sylvan resolved its final contingency early, negotiating a $43.5 million 1998 cash-and-stock payment that was less than what the sellers stood to earn. Sylvan developed that nuance, sort of a discounted "earnout buyout," to accelerate a payoff when it believes sellers are positioned to make their goals. "Both the buyer and seller are interested in defining certainty now," Creamer explains. While the seller eliminates uncertainty over whether it will lose its bet, "we get out early, at a discount to what we would otherwise pay."

The relative complexity of the typical earnout may seem a severe handicap in the current environment, when simplicity is in vogue with investors. "There's something to the complexity discount" being applied to stock prices these days, Creamer concedes. "Shareholders prefer a simple story." But he thinks investors understand that with earnouts, "we're paying for outperformance," and not just complicating things. Sylvan plans to keep using them.

But not Brooktrout's Giler. "We are definitely a case of once bitten, twice shy," he says. "More often than not, earnouts don't work." As long as an earnout lets a value discrepancy stand between buyer and seller, he says, "you're forestalling the inevitable; eventually, somebody will win and somebody will lose."





Roy Harris (royharris@cfo.com) is a senior editor at CFO.























A Turn to Earnouts

Though small, the percentage of U.S.deals containing contingency terms is climbing.

YearValue of deals ($ millions)Number of dealsPercent of total dealsPercent of smaller deals*
19959,694.91631.83.7
19968,575.11711.73.3
199711,849.02652.44.8
199812,965.42712.24.8
199914,571.22121.94.7
200027,934.62662.45.4
200117,357.72233.06.8
2002**4,392.2744.09.7

*Value at or below $250M
**As of 4/24
Source:  Securities Data/Thomson Financial

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