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Key Takeaways
- Protecting key personnel, employment terms and system audits is crucial for ensuring earnouts.
- Negotiating protective clauses early can prevent disputes and safeguard against revenue losses.
When he sold the company he founded, James inked an earnout deal that was based on his team reaching revenue targets for the next two years. But after the acquisition, several key team leaders left the company. Sales faltered, revenues didn’t meet their targets, earnouts were canceled and James lost millions. James left the company, as well.
He and his buyer didn’t agree on whether James fulfilled his obligations, which delayed the sale, damaged their relationship and resulted in huge losses for James and his team.
Founders, listen up
As a founder, James should have kept some things in mind during the earnout negotiation process.
1. How important is your role?
First, he should have considered how important he was to the success of the earnout. Since he played an important role, he should have confirmed that employment termination would not impact the earnout being achieved.
Typically, that means that the earnout criteria are deemed achieved if you are terminated (perhaps limited to terminations without cause). Otherwise, and assuming it’s likely the earnout won’t be achieved if you cease to be employed by the company, the buyer can deprive you of the earnout simply by terminating you. Conversely, the buyer might be incentivized to keep you, because achieving earnout goals may be good for them. But things change. The buyer might decide to pivot and focus on other priorities; that shouldn’t impact your right to the earnout.
If the right discussed above is limited to terminations without cause, it’s critical to be clear about what “cause” means. Cause definitions are often negotiated in detail, because the more flexibility the buyer has to determine whether cause exists, the easier it is for them to terminate you without repercussion. Similarly, avoid giving the buyer opportunities that may result in you leaving, like cutting your salary or demoting you. For the earnout to be achieved, you’ll need to quit with “good reason.”
2. Who’s on your team?
When several key team leaders left the company, the chances that the earnout would be achieved faltered. James should have ensured that they had protections, which can come in different forms. For example, if the team leaders were terminated without cause, one can negotiate for an acceleration of the earnout (as discussed above). Or, to ensure there is enough staffing to achieve earnout goals, one could negotiate for the right to hire new team members if key team leaders leave.
3. What systems need to be in place?
Tracking systems can help identify whether earnout metrics are being achieved, and they must be available for auditing in the event of a dispute, especially if the earnout is based on revenue or other financial goals. For example, when dealing with revenue goals for certain products, a founder should make sure that the buyer’s financials transparently show the revenue for just that product so it can be audited later. If, for example, the earnout goal is increased website traffic, making sure there is an agreement on a method to track visitors, like using Google Analytics, will be important.
While these systems can offer reassurance, James could have considered building in additional resources to ensure his earnout was met. For example:
- Would he need a specific budget, and would he be able to control how that budget is utilized?
- Are there certain types of employees or contractors working on the earnout goals? Did James need a specific number of people to maintain those roles?
- Did he need the company to refrain from diverting him or his team to non-earnout-related goals?
- Should he have made sure the company wouldn’t do anything to compete or interfere with the earnout goals?
- What about ensuring the company does not discontinue the project or cease offering the product that is relevant to the earnout?
If the earnout was milestone-based, James would have needed objective criteria without giving the buyer too much discretion. There are several reasons for this:
- An earnout is sometimes tied to product development or other non-financial milestones.
- If the criteria are vague or subjective, it can be difficult to prove that the earnout goals are met.
- An acceptance procedure is also important. When presenting the “deliverable” to the company, they will either accept it or indicate what is wrong with it and give you time to fix it.
4. Will there be any earnout disputes?
To prepare for potential earnout disputes, James should have had protections and processes in place so he could verify the earnout determinations/calculations. If there was a non-court/arbitration dispute resolution process, he’d have needed assurances of the evaluator’s independence.
Note that this is not uncommon; for example, a business may hire an independent CPA to determine whether earnout goals are met.
3 tips for negotiating an earn out
Details about the earnout should be negotiated in a letter of intent (LOI), a typically non-binding agreement that outlines the deal terms. In addition to being used for negotiating leverage, an exclusivity clause in the LOI prevents the seller from considering alternative offers while negotiating the term’s agreements. After the LOI is signed, however, founder leverage is lost.
Earnout disputes are common for a reason: Anything necessary for a founder to meet the earnout — and that’s left to the buyer’s discretion — can be used against the founder. Always assume that the buyer won’t be aligned with a founder during the earnout period.
A buyer may pressure a founder or present facially legitimate arguments to give in on protections. For example, they may say that these are a small part of their business and cannot make larger decisions simply to protect the founder’s ability to get an earnout. While they are correct, the consequences of business decisions they make on a founder’s ability to meet an earnout goal is in their paying the earnout compensation.
While these tips won’t guarantee an earnout, heeding them will ensure that the buyer doesn’t “game” things against the founder, like minimizing the founder’s ability to achieve goals or do so in a timely manner. But if a founder has ensured auditable earnout data has been maintained, they can be more assured that the buyer will be kept honest in how the earnout goals are evaluated. Conversely, if auditable data is not kept, or if it can’t be audited, a founder may never be confident in a buyer’s claim that the earnout wasn’t met.
The bottom line
Even if they’re not malicious in intent, buyers can potentially impede the founder from achieving the earnout — with no recourse. Putting the proper protections in place during the earnout period is critical to the earnout being paid.
Key Takeaways
- Protecting key personnel, employment terms and system audits is crucial for ensuring earnouts.
- Negotiating protective clauses early can prevent disputes and safeguard against revenue losses.
When he sold the company he founded, James inked an earnout deal that was based on his team reaching revenue targets for the next two years. But after the acquisition, several key team leaders left the company. Sales faltered, revenues didn’t meet their targets, earnouts were canceled and James lost millions. James left the company, as well.
He and his buyer didn’t agree on whether James fulfilled his obligations, which delayed the sale, damaged their relationship and resulted in huge losses for James and his team.
