-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.
With new funding difficult to come by, many cash-burning startups are finding that they have no choice but to take a scrap sale. Those desperate deals cut M&A spending on VC-backed startups in the second half of 2008 by nearly three-quarters over the same period in 2007. From July to December last year, 100 venture-backed startups got acquired, for a total bill of just $3bn. That compares to 153 startups sold for a total of $11.1bn during the same period in 2007.
And we’ve seen more of these types of deals so far this year. Oracle, SAP, Barracuda Networks and Quest Software, among other large technology buyers, have all purchased companies for less than the money raised by the startups, according to our estimates. Consider the specific case of Mirage Networks. The network access control (NAC) vendor raised some $40m before discovering that NAC wasn’t really a market after all. (The eight-year-old company generated an estimated $5m in sales last year.) Trustwave picked up Mirage for some $10m, we estimate. Meanwhile, Mazu Networks will have to hit all of its earn-outs to make its investors whole again. About a month ago, Riverbed Technology said that it would pay $25m upfront for the network security vendor, with a possible $22m earn-out. That’s actually not a bad outcome for unprofitable Mazu, which we understand was burning about $1m each quarter. And yesterday, Netezza picked up the assets of data-auditing and protection vendor Tizor Systems for $3.1m; Tizor had raised $26m from investors.
VC-backed tech startups M&A
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Source: The 451 M&A KnowledgeBase