Ed Sim, a founder and managing director at NY-based Dawntreader Ventures, doesn’t want to offer up a judgement on the eBay-Skype deal (We do: We think it has been a disaster for eBay) But he does see a lesson in the deal’s structure ($2.6 billion upfront for Skype, plus an earnout of up to $1.7 billion more): Sellers are usually better off taking less money and getting it all upfront. You can read a longer version of this post at Ed’s blog BeyondVC.
Quite simply, be wary of performance based earnouts unless you get significant value upfront. Many times an acquiring company may say that they can’t pay higher than a certain value for your business, but if you perform they can pay a lot more. In other words, they want you to put your skin on the line and also incent you to stick around. That’s fine — as long as you get more than enough upfront for your business so that any dollar from earnouts is pure upside. If you feel that you are not selling for enough, and that too much is tied in the earnout, then trust your gut and either rework the deal or walk away.
Earnouts sound great in theory — the better you perform the more you get. In practice it doesn’t always work out well. First, earnouts could potentially put the acquiring and target company at odds by creating potentially perverse incentives for the acquiring company: Hmm, the company I just bought is doing great but I don’t really want them to hit it out of the park just yet. Maybe I should delay giving them their marketing dollars… You can think of a bunch more examples on this front.
More importantly, though, I feel that unlike a startup, once you’ve been acquired you have relatively little control of your own destiny. In any M&A with performance numbers, the acquiring company will say it is offering resources, distribution, etc. and therefore the revenue, profit, and customer targets should be quite high — yet attainable. But in a startup, if you fail it is your fault. As part of an operating business or larger entity that isn’t always the case. You are most likely dependent on the acquiring company for resources, distribution, and cash to grow and deliver on your promises. Big companies move slow and you are more likely to not get the support you need in a timely manner — meaning that realising your earnout becomes a very tough proposition.