Are earn-outs cop-outs?

-Contact Thomas Rasmussen and Yulitza Peraza

Despite being derided by some as cop-outs, earn-outs are nonetheless popping up more frequently in deal terms. It used to be that the staggered payments were a way to keep the talent at the acquired company from bailing as soon as the ink was dry on the deal. Now, retention isn’t so much the concern, it’s more valuation. Earn-outs are being used to bridge the increasingly wide gulf between buyer and seller expectations.

So far this year, 18% of deals with an announced value of less than $500m had an earn-out provision, up slightly from 15% for the same period in 2008. However, the additional payments are making up a larger part of potential deal values. The average earn-out amounted to half of the deal value in transactions announced so far this year, compared to just one-third during the same period last year. We would attribute that to the leverage buyers have in the current M&A environment as well as their need to preserve cash.

And, anecdotally, we have been hearing that buyers are using their position to set unrealistic terms (thus avoiding payouts down the road, and preserving more of their cash). Consider the case of Mazu Networks, which sold to Riverbed Technology last month for $25m in cash and a potential $22m earn-out. Combined, the upfront and earn-out payments would have nearly made whole the investors in the Cambridge, Massachusetts-based security company. But a closer look at the terms reveals just how unlikely it is that Mazu and its backers will see much – if any – of that earn-out. The reason? To be paid in full, Mazu will have to more than double its bookings by the end of March next year at a time when the economy is shrinking and even tech stalwarts are struggling to post any revenue growth.