Are earn-outs are the best way to sell a business?

Tony Tighe of Mere Communications – the veteran of a few such deals himself – summed up the position thus: “What happens when the earn out is over? Ideally you don’t want to be seen as a mercenary and walk away and start again. It makes total sense if you are encouraged to stay on after the earn out period.

“It is like a footballer’s contract. They all renegotiate near the end of a deal. If you don’t, you’ve lost that entrepreneurial skill that established the business. You need to look beyond the earn-out. Otherwise it is short-termism.”

But are earn outs a good idea in the first place? What about simply extracting a cash price when you sell a business and walking away at the outset? Much better says Paul Carroll of Zuma011 who says the restraints an earn-out can impose on both buyer and seller, can be dangerous.

“You are subject to conditions and the market, for instance, may suffer a downturn,” he says. “It’s like selling a house – you don’t want to get half the sale price upfront and the rest over the next five years, depending on how pleasurable an experience the purchaser found it.”

From the seller’s point of view, Carroll believes the burden on the owner selling the business is too onerous, financially, and likely to impact negatively on the overall success of the company. “If you are selling something very strong and profitable, you don’t really need to be taking an earn-out. A lot of earn-outs are basically the potential to earn more, with just a little bit up front. The purchaser is not taking much of a risk and it puts all the onus on the person who has sold.”

He also believes the change in emphasis can impact heavily on workforce morale, as the original owner is perceived differently.

“When you sell a business run by an owner-manager, he or she drives it with their own energy and passion, getting performances out of its people. That is what gets the performance up, but the dynamics change considerably when you sell. The same applies to clients. You can lose clients as a result of selling. They might have liked dealing with person A, but think they are no longer interested because they have cashed in. The whole

dynamic changes.”

Brian Child, formerly chief executive of McCann Erickson – now non-executive director of the Mission Group – agrees that maintaining a solid relationship is crucial, but he supports formalising an acquisition to ensure a guaranteed performance.

“It is like a marriage. A lot depends on how both partners interact. It is based on trust. Both parties should want this to work.” As an insurance against that goodwill evaporating, Child supports securing an earn-out deal, to commit the selling owner to maintain past performance.

“Earn-outs are necessary. When you buy a company, all you are buying is history. You have paid for the history of that company, and you are buying future performance. There should be some guarantees. The point of the business moving forward is that the person selling the company commits to a certain level of performance.

“It shouldn’t be a disincentive. The earn-out is an opportunity for people to earn even more money.”

Despite being highly incentivised – and the inclusion of restrictive covenants in the event of a failure to match the expected performance - if the targets are not met, Child says there is no remedy, and both parties will have no option but to turn their backs on the deal.

“The bets are off, and the seller can walk away from it. That is what happens in reality if it is not working out. There is usually nothing that can be done. It is a bit like sunburn – there is no cure for it, just prevention.”

Tighe says the biggest challenge for someone on an earn-out deal is balancing your own financial interests – in the form of your final payment – against the long-term interests of your business. Major decisions such as acquiring new premises or opening new offices can incur a short term loss.

“The difficulty is making decisions to run the business with your business head on as opposed to the earn-out head. How do you balance the future development of the business against your two or three-year earn-out?”

In Tighe’s view, one solution would be a rolling renegotiation of the deal.

But Carroll warns that the principle underpinning an earn-out deal is essentially flawed. “To have the main remuneration for running a business to come from a future formula is fraught with difficulties. Quite often it’s the driving force of the principals of the business who give it that performance. Once they land a big payment up front, there can be a tendency not to work as hard, and financial performance dips.”

This runs counter to the incentive theory of earn-outs, but that idea, says Carroll, quite simply doesn’t work in practice. “Companies buying often cite the earn-out as being a way to keep those persons performing, but you would end up feeling like a slave in a castle you had built yourself. Why do you buy a business that is so dependent on people? They say the earn-out keeps them on track, but it doesn’t.”

As for Bell and Cheetham, the future remains unclear. Cheetham is believed to be busy working closely with JWT on a number of global projects and the consensus is that he’ll continue to lead CBJWT’s creative efforts from Manchester.

Bell, however, is the subject of increasing speculation. Even if he leaves, which some have anticipated, he’s unlikely to leave the agency scene altogether. He still controls 50 per cent of Brazen PR, despite a highly public end to his personal relationship with the consultancy’s managing director Nina Wheeler – who owns the other half of the business – at the firm’s fifth birthday party.

On the Cello front it is thought negotiations are well underway to keep the Target founders in place.