When earn outs can hurt

When earn outs can hurt

We can only sympathise with the 51 vendors and their partners who sold their businesses to the listed, marketing services group Photon on a cash-and-earn-out deal over the past few years. Most were left wondering if they would ever see the balance of the money promised by Photon when acquiring each of the businesses.

Photon recently announced that it had reached an agreement on how it will pay $176 million in earn-out payments owed to some of the 51 companies. The announcement reported that about one-third will be paid on the original dates agreed and a further 15 percent will be issued in scrip on the date of a planned capital raising. The final tranche will be paid to companies conditional upon the group , and not the individual companies, reaching certain targets. The capital raising of $100 million is set to be marketed during August and those companies affected will no doubt have a white-knuckled ride as stock markets remain volatile.

Earn-outs for both private and publicly listed companies have been a technique used for many years. Although private companies rely on cash earn out payments, listed companies have the benefit of issuing shares. The premise behind earn outs is straightforward: a buyer pays the full price (or near) of a seller disposing of their business but only if certain milestones either in revenues or, more usually in EBIT terms are met. In the Photon case, for reasons that are more to do with its own balance sheet, the earn out is based on their capacity to pay.

Now a common feature of many acquisitions, an earn-out stipulates that the original owners of a business are paid for the sale of their company, following which they are (usually) contractually obligated to stay with the company through a transition period, and they are provided with the incentive to have a demonstrable effect on the company's financial performance going forward. Achieving or exceeding a certain level of performance – criteria are typically set over a period of several years – means the original owners will potentially earn a much larger profit from the sale.

For buyers, an earn-out can offer the owner protection against overpaying for a company that doesn't end up thriving or growing in the way its original owners expected. It can also smooth the period of ownership transition. The lesson form Photon: caveat vendor: let the vendor beware.

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Tags mergers & acquisitionsPhotonearn out

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