UK: Getting Creative With Earn-Outs

The past couple of years have not been kind to the media industry – marketing services have been particularly hard hit. Advertising agencies, public relations firms and ad-driven publishing houses have all struggled as a result of the downturn in advertising spend and the tightening of client’s budgets. But the sector is starting to turn the corner. Since hitting a low in March 2003, the FTSE Media and Photography index has been climbing steadily.

Deals involving earn-outs have traditionally been the commonest way for the owners of creative organisations to exit and extract maximum value. Earn-outs overcome the inevitable hurdles that exist when the value of the business is tied up with the owner’s involvement in driving that business forward. Other options are available to but each have their pitfalls. A sale involving a simple one-off payment on completion is likely to undervalue the business and a flotation, while usually providing some realisation of value, is not guaranteed to result in a total exit for the owners. A management buy-out by other members of the team is another possibility for owners seeking an exit, but external financing can be difficult to attract with both private equity houses and banks being particularly wary of ‘people’ businesses. Hence the popularity of earn-outs. Today’s improving market makes it a good time to take the plunge whichever side of the transaction you are on.

To understand why earn-outs are often employed in such deals, it is important first to look at how earn-outs work. The buyer and vendor negotiate a price structure whereby the buyer pays up front a certain percentage of the estimated total price on completion. This can vary but is typically between 30 per cent and 60 per cent and will be based on a multiple of historic profits. The selling shareholders of the acquired company will then be locked into the company for an agreed number of years (typically three to five) to continue to run the business under its new ownership. Subsequent payments during the earn-out period and the final payment at the end of the period are linked to certain targets, usually profits.

In today’s rising market, short-term historical profits are likely to be at a relative low but prospects look good. This can potentially favour both parties: although vendors will get less up front, because the payment is based on achieved profits, their subsequent and final payments should increase with the rising market. Meanwhile, this can reduce buyers risk by paying a lower consideration up front, and although the earn-out payments will rise if the business starts to make healthy profits, those profits mean that the acquired business has to deliver more value.

To limit the upside, buyers are likely to set a cap on the total pay outs – indeed publicly quoted companies must do so. In a typical deal, a vendor could expect to receive the up front consideration and then at least as much again over the period of the earn-out.

But getting the right price for an acquisition is vital. If the buyer pays too much up front, and profits are disappointing, they will be left with a bad deal having overpaid for the business. If the buyer offers too little, there is a risk that the deal will not proceed. Some companies in the media sector have run into difficulties by overpaying at the peak of the market when historical profits were high, only to see the acquired business fail to deliver in a difficult market. In short, an earn-out deal helps mitigate risk for the buyer and, if things go well, means the vendor walks away with a better price than they would have achieved with a deal involving only a completion payment.

Another key advantage of an earn-out is that it gives the buyer an opportunity to get to know the business under new ownership, while it continues to be run by the vendors. During the earn-out period, the buyer needs to ensure that they protect the value in the acquired company by starting to install new management who will take over the reins when the vendors eventually leave. This provides the potential for conflict during the earn-out, as the vendors will not want to bear the costs of training and developing the new management, but if the deal is to work for the acquirer in the long-term then this issue must be resolved early on. Most vendors will realise that, in many ways it is easier to manage succession during the earn-out at the buyers risk, rather than to attempt to put plans in place in the run up to a deal.

Trust is fundamental to a successful earn-out. A vendor must be confident that not only will the buyer be able to pay out on the earn-out commitments made in the sale and purchase agreement. But also that they will provide support to, and not frustrate, the business during that period to give it a chance of achieving its targets. Trust is particularly important when the buyer wants to integrate the new business into an existing division and will require careful planning and negotiation when structuring the deal.

It is vital to agree clearly in advance exactly how the profits of the acquired business will be measured – it is after all, the basis for the final payment. If the new business is to be run completely independently, it should be easy to ring-fence its profits so they can be monitored accurately. It gets more complicated if the acquired business is amalgamated into an existing division of the acquirer. Then, ring-fencing becomes virtually impossible and tensions can arise if the existing business is perceived to be dragging the new business down, having an adverse affect on the final pay out.

At the same time, keeping the new business separate risks encouraging its management to focus exclusively on their own results. They might prioritise short-term solutions that are not in the best long-term interests of the group. This can be mitigated by locking managers into the company as a whole either through options or simply by opting for a part share deal. This ties the vendors in for a period post deal and gives them an incentive to ensure a good performance by the whole group and not just the business they sold into it. With favourable market conditions and a positive financial performance, any rise in the share price would also prove attractive to the vendors.

It is clear that communication between the buyer and the vendors is crucial – both in negotiating the deal at the outset and then running the business during the earn-out period – they will not work if the relationship breaks down. While complex to structure and operate, earn-outs are an intrinsic part of most marketing services sector transactions and are the best framework for the vendors and buyer to extract the appropriate value in the business. They also provide the best opportunity for the vendors and the buyers to manage the succession issues that are vital to people businesses and mitigate against the risk of over-paying but under-delivering.

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