When An Earnout Goes Bad

Our M&A practice has taken some strange turns over the decades. Here are a few examples:

• Managing a purchase where the seller was going to be appointed to high government office and couldn’t have an earnout.
• Selling to the firm’s largest client, all cash at closing (x3).
• Mental breakdown in a seller, one day before closing, leaving $1.4 million on the table.
• Young owner died of a sudden heart attack and non-participating spouse asking for help to transition to employee. Firm is thriving.
• Same thing, but a drawn out process via cancer. Firm is also thriving.
• Discovering massive embezzlement by key employee right after transaction closed.
• Helping to put someone in jail by secretly recording a conversation when we knew the no. 2 executive was scamming the employer.

One of those instances was helping a client who was already smack dab in the earnout, suddenly finding himself with an unethical buyer who was trying to cheat him out of the earnout.

We don’t just let our clients get purchased by shit firms, but there are times when an earnout goes bad. That’s what this article is about.

Important Disclaimer

I want to say something important before we get started. You should always default to negotiating in good faith, which will invariably lead straight to an earnout that’s also navigated in good faith.

If, during the negotiations, you start getting nervous about the buyer, that’s the time to dive deeper into that gut instinct, to either resolve it or maybe walk away. That scenario might look like:

• Untruths about something. The buyer tells you one thing and you learn that there’s an important backstory that shines a different light on what you were led to believe.
• There’s an unfriendly firmness in resolving some of the nuances in an agreement. A purchase agreement might run 40 or even 80 pages, and they are exhausting to read, much less to write. It’s counterproductive to try to anticipate every single element that might surface after the transaction closes. So there absolutely will be scenarios where the other party will have an opportunity to follow the letter or the spirit of the agreement, and what they do in those moments will be revealing.

When the two parties keep dragging the agreement out and pointing to specific language in a dispute, you have entered a new zone. Of course, you could be the bad actor in this situation, in which case I’m just going to say stop it and be a fair human. But if the other party is squeezing you unreasonably, and bad blood is starting to rule the day, and you’ve decided in your head and your heart that you don’t want to work here after the earnout ends, and if the earnout is starting to feel more like imprisonment than an opportunity to do great things together, you might very well need to protect yourself.

The reason I’m writing this at the outset of the chapter is because it must be seen as a Plan B. It should not be the default behavior on your part. But two can play this game, and if someone pulls out a weapon in what was earlier described as a fist fight, well, someone changed the rules and it wasn’t you.

So please read this as a defense if you need it, and not how you should normally act. The other way you could read this, if the tables are reversed and you’re the buyer, is to tighten up your agreements to prevent some of the loopholes I’m going to describe below.

You’ll already know the normal ways to maximize your earnout, and that’s not what we’re talking about here. This is just to suggest some ways in which you can give yourself an unfair advantage if the buyer is going to get all technical and “by the book” on you and try to minimize what you can earn. Press this too far and you’ll end up in a legal dispute, which no one wants and hardly anyone wins, but sometimes all you need to do is to give yourself some better leverage as you look to clarify your standing within an earnout. In other words, you might simply suggest that you’ll have to resort to one or more of these tactics, and that might be enough to move the discussion closer to a resolution. Here are seven tricks to keep in your back pocket.

Arbitrage Your Labor

Chances are good that your earnout is tied to profitability. The projections you’ve made to anticipate what you might receive in an earnout are based on using the same labor force that you brought into the transaction. This is the same labor force that you have worked hard to protect by assessing the buyer’s culture thoroughly and arranging reporting relationships to minimize disruption and so on. But if the deal has now turned a bit adversarial, some of your people may not want to stay, and it might be appropriate to near- or far-shore your labor and arbitrage the difference in cost (selling to clients at the same price while costing you less to staff the function). It’s unlikely that this will ever have been addressed in a purchase agreement, and so it’ll be there for the taking.

Accept Client Concentration

A client concentration challenge is defined as having one related source of work represent 15% or more of your total billing. That target varies by subindustry within the professional services space. Normally, you’d want to avoid this problem for several reasons:

1. Your firm will be at risk if the client leaves.
2. You’ll slowly be drawn away from an expertise role into more of an order-taking role as you functionally become their in-house department.

The risk identified in that first point might still be there during the earnout. But in an adversarial setting, you’ll be more interested in what happens now and less interested in what happens to the acquiring firm after your earnout is done.

It’s much easier to sell while walking the proverbial halls of an existing client than it is to land a new one. Satisfied internal contacts can introduce you to their colleagues, you’re present in their planning meetings and might get first crack at leading a new initiative, and there’s just a massive “go with the flow” kind of momentum you can take advantage of.

And if you aren’t too concerned with what happens after the earnout, and if all your business-building efforts within that one entity will help you in the short term, why not?

Defer or Skip Large Expenses

Again, this is not how you’d want to run things under normal circumstances, but you’ve now been handed an incentive to maximize the short term. Since your earnout will likely be tied to some profit or EBITDA number, maybe don’t transition to that far more expensive SaaS platform that you’ve been wanting to use, cut that conference sponsorship that is about building long-term relationships with the right people, spend less on your marketing plan when you no longer care about the long tail, don’t spend as much money on training and development, cut the entertainment back, and convert client travel to online meetings.

These are not the responsible steps to take when you’re in it for the long haul, but they are exactly what you’d do in a downturn—in this case the downturn is in the relationship and not the economy.

Lease vs. Expense

Section 179 changes in recent years have allowed businesses like yours to spend a lot more on equipment purchases and expense them in full when they occur, rather than spreading the expense out over time. The tax incentive underlying those changes was meant to promote purchases that are good for the economy and good for your firm’s performance while giving you a legitimate way to reduce your taxable profit.

But you can also look at that same taxable profit as a big number in your earnout calculations, and taxation isn’t quite so top of mind like it was when you were running your own firm. So instead of buying things outright and capturing all that taxation advantage, reducing your profit in the process, consider renting or leasing what you need, instead. You have to be careful with that because there are operating leases and capital leases and the transaction needs to be done carefully, but this is another way to boost your earnout calculations while deferring some of the expenses that you would have swallowed whole and move them forward to hit the books after your earnout is complete.

Quicker Staffing Adjustments

Here I’ll mention again we’re past the culture-building phase and we’re in a “grab what you can” stage. The staffing continuity isn’t as important because your team feels like you do about the long-term prospects of working at the buyer’s firm past your earnout.

This means that you might make a quicker staffing adjustment rather than hang on and ride out a downturn. Or maybe you use more of a Hollywood staffing model, where you assemble freelancers for each big project and they move on when the project is done.

Maybe you don’t jump at hiring that once-in-a-lifetime-opportunity star that you don’t need quite yet, where in the past you would have added them to the team and then found clients who needed that capability.

Narrowly Targeted Marketing Activity

Normally you’d want all the marketing activities to be coordinated from the top and to build the firm’s brand as a whole. But if your incentives change and now you’re forced to be a bit more self-protective, you might tailor some outbound initiatives more narrowly.

You might participate less in cross-selling in ways that serve the firm’s future outside your own earnout considerations and instead gather opportunity for your area of control. It can’t be unbranded from the whole, but there’s no reason you can’t go after narrow engagements where a new client doesn’t use all the service offerings under the company umbrella, focusing instead on just using yours. This would entail a highly concentrated sales effort where you aren’t spending any extra time or money on spillover effects for the other parts of the company that are outside your earnout calculations.

Shift Engagement Timing

Here I want to emphasize again that you’re staying within the letter of the law in your earnout agreement so that you can live with yourself and defend your actions—but there’s no reason that you can’t be more self-interested in when an engagement is consummated (accrual accounting) or when it is paid (cash accounting).

This would be especially useful if your earnout is structured around cliffs rather than ramps, and missing some target by a small amount results in an inordinate impact on your earnings. You never want to play fast and loose with client deposits and unearned income, but you can phase your engagements to account for how the earnout is calculated, by accelerating—or even deferring—when those hit the spreadsheet that’ll be used in the calculations.

Finally

None of these tactics are optimal in a respectful relationship with the buyer of your firm, but you can resort to them if your new bosses decide to play that game. You can even tip your hand about the possibility of using them to improve your negotiating position or extract some concession in how the purchase agreement will be applied, and then carry on as normal.

Maybe print these out, laminate them, and put them in one of those little red boxes marked “Break Glass in Case of Emergency”.