Earnouts

Earnouts give sellers the opportunity to earn more based on fulfilling certain metrics or achieving specified milestones.

How common and significant earnouts are will vary over time, by industry, and depending on the market and economy. The American Bar Association¹ says it expects earnout clauses to become more common and make up a larger percentage of payouts in the aftermath of COVID-19. Expect earnouts to be present in more than 30 percent of deals and to make up nearly half of the purchase price. For life sciences startups, earnouts may be found in more than 60 percent of M&A transactions. They may also last longer. (Consider an average of 24 months at the beginning of 2020 to three to five years post-COVID.)

Business Law Today² reports that 11 percent of earnouts are greater than five years, and that in 30 percent of cases, earnouts are indefinite or the time line is “silent.”

Founders also need to factor in the risk that they cannot meet objectives, especially when there are extreme circumstances, market shifts, and cycle turns that may affect the ability to deliver on the goals and criteria for earnings.

Here are the most common earnout metrics:

• Revenues
• Earnings
• Regulatory milestones

Earnouts can also be tied to these criteria:

• The launch of new products
• Sales volume/units
• Expansion

These two groups can also be combined to make earnouts more complex.

Another major factor to consider is what happens to earnouts when your buyer is acquired by someone else during this period. It is probably more common than you think, and it can make getting paid far more complicated. Ideally, as the seller, you want your earn-out payout to be accelerated in this scenario.

Perhaps most important is the ability to work and operate in a way that enables you to achieve these earnouts after the closing. You might be surprised to learn that in 98 percent of deals, buyers may make no written agreement to run your business in a way that helps maximize payouts. Very few agreements even promise the company will be able to run as it used to or that there is any fiduciary responsibility of the acquirer.

The following are indicators that you may be in for a rough time:

• Combining business units
• Combining your products with theirs
• Selling off material assets
• Laying off employees and management

Good signs to look for include these:

• Providing money for capital expenditures
• Hiring more
• Providing your company with access to their resources
• Keeping the businesses and accounting separate

How dispute resolution is laid out can potentially be a sign of intentions as well.

Revesting

If you did your homework and applied appropriate vesting strategies in putting your own startup together from the beginning, this should not be a foreign concept for you.

The vesting period is a safety measure that enables those with stock options and shares to earn their stake over a period of time. When you launch a startup, the last thing you want is several founders or key team members being given significant amounts of equity, only for them to quickly disappear, not put in any work, and then get just as much financial benefit as you do after you've sweat, bled, and burned yourself out for years to make your company succeed.

You can understand that in an M&A deal, the same concerns apply to your new acquirers. They don't want you to just toss them the hot potato while you run for your bunker with all of the proceeds.

In contrast to earnouts, revesting is time-focused. It is about proving what you said and the value over a period of time. It can also be about locking you and your top talent up so that you aren't out there competing against them and devaluing their investment.

When you are given stock in the new company for your sale, a percentage of this won't be vested, or really become yours, until the vesting period or its milestones are up. There may be some tax advantages to spreading out these payments, though these rules are constantly in flux. This revesting period may last one to four years or even longer, though you may receive lump sums at various milestones and preset dates throughout this period.

For example, if you and your cofounder sold your startup for $100 million, and 60 percent went to your investors, then you and your cofounder may each get $5 million per year for the next four years, provided you stick with the new organization. Or, if you can shorten that, you could get $10 million at closing and another $10 million at the end of the first year after the acquisition.

How you structure and word the value of these payouts and earnings can make a big difference, too. Are you being given a fixed dollar amount? Or is it a certain number of shares, which could be worth dramatically more or less by the time they are fully vested?

Sometimes revesting is sold to entrepreneurs as an easy gig—just showing up to clock in for a couple of years. Of course, any true entrepreneur isn't cut out for that. You're not designed to tolerate just checking in for mindlessness every day for any period of time. Being locked in those golden handcuffs can feel like a fate worse than death for those who survive on doing something: doing something meaningful, having an impact, and having a purpose.

Hopefully you will have the ability to really do some meaningful work and keep creating progress and results and see your mission being fulfilled during this period. However, it can depend a lot on the written terms of your transaction and the reality of the promises made after the fact. Having chosen your buyer well will make all the difference for this phase of the journey.

What you don't want is to be at odds with your new bosses and their ethics and then wind up walking away from millions or billions of dollars. That's what happened to the founders of WhatsApp, when Facebook had different ideas about what to do with their data. The two cofounders had to walk away from $1.3 billion in payouts because they simply couldn't take being there for another 12 months.

If you do find yourself in this situation, then it is worth attempting to negotiate an early buyout. That may have to come at a discount. Or if the integration and new asset just isn't working out for the acquirer, then you may be able to buy some of it back.

On the bright side, this could be an incredibly empowering period during which you enjoy learning many new things and making new connections, which may prove pivotal in your next startup venture.

Start Early

Integration can't be an afterthought. It can't be something you wait until after the closing to address—at least not unless you don't care if it is successful or has a fighting chance of working.

Integration shouldn't be addressed only in financial negotiations. Plans and efforts should already be in progress in advance of the closing, as much as possible.

Leading the Integration

Integration requires great leadership. You can't do it all yourself. As the seller you only have so much power, and there can be some natural headbutting because of your position. Your companies will hopefully be able to form a strong and balanced integration team. You may also want to employ a change management expert who knows how to handle these challenges and weld companies together.

A third-party expert can also greatly help eliminate power struggles and “us versus them” mentalities—at least while people get used to the new power structures. Then, make sure teams are clear that the challenges of this integration are what they need to work together to solve, instead of competing against each other.

Create a Time Line

Draft a time line with your acquirer for how you'll merge your businesses together, as well as for the next steps for your operations.

Create a Detailed Action Plan

Just as with launching your startup, know the big things that need to be achieved over the months ahead, while maintaining a very short and focused list of your next one to five action steps:

• Deciding how much autonomy your company will have or not
• Creating a new organizational structure map
• Handling new employee contracts and benefits transfers
• Managing layoffs
• Merging and replacing technologies
• Combining communications
• Implementing new accounting systems

Document a System

Bain³ reminds us that it is important to document and systemize. Create a repeatable process. It probably won't be your last M&A deal. At certain points in the future, you will probably be on one side of the table or the other.

Culture

Integrating teams and culture is the most critical component here. If people aren't working together, then they are working against each other. There is enough competition out there, without competing against your own organization internally.

Culture is probably the number one factor—not just in integration but for the success of business in general. Although each office and country may have its own culture or variations and spin on this culture, there can be only one company culture going forward. It is probably not going to be the same scrappy, small startup culture your company came in with.

However, if you make sure there is a good match in cultures even before you begin seriously talking about an M&A deal, then things should work much more seamlessly. Despite location and size differences, you may be surprised to find how well things can mesh together, especially with people of the same caliber and with the same ethical values.

Getting team members together as much as possible and empowering them to bond on a personal level can go a long way toward a smooth integration as well. Getting together off-site can be a fantastic way to achieve this. In times when this isn't possible, consider how to get them together in smaller groups online in as human an interaction as you can.