Earn-Outs (almost) never work

New York Times reported today that Disney will get a 50% discount on its purchase of Club Penguin because the company failed to meet the targets needed to earn the extra payment. Now, don’t feel bad for Club Penguin’s founders. They still made $ 350M (the company had no outside funding). Still, this story is a perfect illustration of the issues with earn outs when you sell your company.

Earns outs are commonly used when there is a disagreement in price between the buyer and seller. The buyer will pay some amount upfront, with more to follow if you hit agreed upon targets.

Why are earn-outs bad? An acquisition is supposed to be a beginning of something strategic and long term for the buyer. But from day 1, you are coming into that relationship with a big disagreement over the value of this asset. This can create frustration and bad blood.Your motivation is to earn that extra pay out. But your buyer’s motivation is to not pay anymore. What does that to do the success of this transaction on a day to day basis?  The two parties are not aligned. This has to impact how they work together, and can ultimately jeopardize the entire transaction value since the  buyer might fail to realize even the value of its initial payment.

When we sold Terrascale to Rackable Systems in 2006 we had an issue over price which almost resulted in an earn out. We got around it by carving out some IP that was not part of our core product line. They ended up buying that extra stuff 6 months later (this was the time window when they were allowed to do that). I don’t think they bought the extra IP because they had a business plan for it. They did it so we would not be distracted. i.e. they did it to get everyone aligned.

In many of the earn-outs I have seen, the targets are not entirely under the seller’s control. They are usually based on sales targets where the buyer’s sales team and channel are responsible. As a seller, especially in a large company, how do you get a sales team that you don’t lead to hit those targets?

There are countless examples of earn-outs that did not work. Probably the biggest one that I know of was when eBay bought Skype.

I guess the lessons here are:

– Avoid earn-outs if at all possible. This does not just mean accepting the buyer’s low price, but talking through the risk to alignment and realization of deal synergies for the buyer if there is an earn out. Help them realize that they don’t want an earn out and neither do you.

– Generate deal competition: Easier said than done, I know, but having more than one potential buyer can reduce price gaps and give you leverage to kill clauses you don’t like (such as earn outs).

– If you do end up with one, treat is a lottery ticket. Don’t expect the money.