Earnouts are ‘litigation waiting to happen’: exec at deal conference

In M&A transactions, it’s not high deal prices, outrageous seller expectations or dealing with private equity that angered executives attending Edison Partners’ Strategic Growth Summit.

Instead, it’s earnouts.

Earnouts are pricing structures typically found in M&A deals. In an earnout, the seller must achieve certain financial goals after a transaction closes to “earn” part of the purchase price.

“I don’t think I’ll use [earnouts] again,” one executive said during the panel “What’s hot in Fintech.” “They’re an enormous pain in the ass.”

“We see it a lot,” a second executive said “We believe earnouts are litigation waiting to happen.”

Vance Shepard, director of corporate development and investor relations at Jack Henry and Associates, who spoke on the fintech panel, said earnouts are to be avoided because they are largely binary. Sellers get paid or the result is a lawsuit. “So, if you were going to pay it anyway, probably best to structure it as something else that is very clear, desirable for the acquirer and almost certain to avoid litigation,” he said.

Edison, a growth equity investment firm, held its first Strategic Growth Summit in Philadelphia last week. Roughly 150 executives from companies including American Express, Fidelity National Information Services, Equifax, Dun & Bradstreet and Societe Generale attended.

Chris Sugden, Edison’s managing partner, said he was surprised by the response to earnouts. Edison has successfully completed many deals that included them.

The Princeton, New Jersey, firm focuses on companies in financial technology, healthcare IT and marketing technology. “Our experience isn’t as uniformly negative the way the panelists were,” he said.

While Sugden is more positive about using earnouts, he does have some advice. Firms that use such pricing structures should have clear terms of engagement to avoid problems, he said. Sugden also prefers revenue-based earnouts as opposed to “bottom-line or EBITDA-type earnouts.”

Earnouts should not include more than 20 percent of deal proceeds, Sugden said. The optimal range is 10 to 15 percent, which would make an earnout big enough to matter to executives but won’t make the buyer feel as if they’ve stretched an extra 10 to 15 percent, he said.

Earnouts also should last only a year. Any longer and the earnout is hard to track, he said. “In an environment where everyone believes valuations are high, we look at performance types of structures as a way to keep management’s feet to the fire,” he said.

Executives speaking on the panel also said team continuity is very important when buying a company. They noted that the CEO may not return if they get “life-changing money” from a sale. “We’d much prefer to know that up front,” one person said.

Another executive of a large financial-services company said they like to be “honest and forthcoming” with valuations in an auction process. Private equity, the source said, likes to “throw out big numbers at the beginning of the process.” Then, they’ll throw out lots of reasons to knock that valuation down.

“We would rather work our way up and get to the valuation than play games with the management team,” the person said.

Action Item: To contact Chris Sugden, Edison’s managing partner, email him at csugden@edisonpartners.com

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