Many moons ago when I was still dating, a woman asked me to give her my five year plan. At that stage in my life, I did not have a five month plan, much less a five year plan. I have to admit that I was a bit taken aback by the pointed line of questioning, so I decided to have some fun with the situation and asked, “Why do you ask? I mean, what I’ve done up to this point isn’t good enough?” Her response was, “Yeah, it’s ok, but I need to know what to expect in the future before making a commitment to you.” (Hah! Just “Ok.”)
The moral of this blog post is to advise tech entrepreneurs not to fall into the earn-out trap. Oh, the lovely earn-out. It is a wonderful tool to get deals done, but it can be a spider’s web. Typically, companies are paid a purchase price and there is an implied multiple based on their trailing twelve months financial results. As your investment banker, it would be my job to apply that implied multiple to your projected financial results, making the case that the the company’s historicals actually its projected year-end results.
Oftentimes, this opens the door to an earn-out situation, whereby the acquirer sees the opportunity to “bridge the gap” with an earn-out. If an entrepreneur is not well-equipped with an advisor that can help them work through the details of an earn-out, they might find themselves committing to unreachable financial hurdles or, even worse, a situation where corporate expenses are allocated to their operating expenses lowering their operating cash flow.
An entrepreneur’s business is just that, his or her business, and it should be acquired on the merits of its market share, defensible product positioning in the market and historical financial results. The purchase price of a transaction should never be based solely on future results. The absolute maximum amount of the purchase price allocated to future results should never exceed 50% in addition to capping the out years at 25% per year for a maximum duration of two years. Otherwise an entrepreneur would be better off keeping his or her business and selling it at a later date.
So, when a suitor asks for your five-year plan, treat this as a red flag warning and be prepared for them to try to tie you to an earn-out based on this forecast. If you are not asked to project your business out five years when selling your company, then you will know the buyer is making a serious run for your company. Always take the posture that you are selling your business and running it for the buyer. Not the other way around, i.e. buying your own business with its future cash flows.
