I am sure you remember the ebay-Skype deal where ebay coughed up $2.6b upfront for Skype and offered an earnout of up to another $1.7b for hitting performance numbers. Besides the value of the deal, what struck me most was that 40% of the total potential deal size was based on performance-based milestones. Fast forward 2 years later and in the day of reckoning it seems that eBay is only going to pay $530mm of the $1.7bb earnout (see Eric Savitz from Barrons post and press release). I am not going to comment here on whether or not the Skype deal was a complete failure for eBay, but rather I thought I would more importantly share my thoughts on earnouts in M&A transactions.
Quite simply, be wary of performance based earnouts unless you get significant value upfront. Many times an acquiring company may say that they can't pay higher than a certain value for your business but if you perform they can pay alot more. In other words, they want you to put your skin on the line and also incent you to stick around. That is fine as long as you get more than enough upfront for your business so that any dollar from earnouts is just pure upside. If you feel that you are not selling for enough and that too much is tied in the earnout, then trust your gut and either rework the deal or walk away.
Earnouts in theory sound great - the better you perform the more you get. However in practice it doesn't always work out well. First, earnouts could potentially put the acquiring and target company at odds by creating potential perverse incentives for the acquiring company. Hmm, the company I just bought is doing great but I don't really want them to hit it out of the park just yet so I may delay giving them their marketing dollars? You can obviously think of a bunch more examples on this front. More importantly, though, I feel that unlike a startup, you have relatively little control of your own destiny. In any M&A with performance numbers, the acquiring company will say it is offering all of these resources and distribution and therefore the revenue, profit, and customer targets should be quite high yet attainable. In a startup, if you fail it is your fault. As part of an operating business or larger entity that isn't always the case as you are most likely dependent on the acquiring company for resources, distribution, and cash to grow and deliver on your promises. Big companies move slow and you are more likely to not get the support you need in a timely manner meaning that realizing your earnout becomes a very tough proposition. Even thinking about the ebay-Skype saga, I can remember reading the countless news items and stories about how the 2 cultures clashed, how ebay did not understand the Skype business, and the management changes and reorgs that took place. All that being said, I am sure the investors are bummed about leaving another $1.2b on the table in earnouts but at the same time they are still ecstatic about the initial $2.6b they received upfront.