Selling your tech company: Earn-Out Pricing Mechanisms

A successful tech business will inevitably attract attention from would be suitors and so at some point, the founding shareholders will be required to make a decision as to the extent to which they want to retain autonomy for driving its day-to-day operations and the level of their own investment going forwards. 

Individuals with a desire to stay with their business as it hopefully develops and grows will need to go through the process of scaling up which could involve raising funds or considering new and much larger commercial transactions to enter into as a way of transitioning from an early stage success story to an established and much larger player in its chosen market. Conversely, other entrepreneurs may have been working with an ultimate exit strategy in mind or else an offer for their business is made which is simply too good to turn down. 

In these latter scenarios, individuals behind a really successful and profitable technology offering, may well be in the fortunate position of being able to negotiate their terms of exit off the back of a particularly strong balance sheet that enables them to receive the full value of their business on day one and to leave with immediate effect. However, equally, a prospective buyer may well consider the founders to be a vital part of the on-going business and as such, will base its offer on the condition that they continue their work and involvement in it following completion of its sale to the buyer - this is a particularly common situation where a piece of technology developed and maintained by the founders is the key selling point of the business being acquired. 

In other transactions, where the balance sheet of the target company isn’t as strong but the business model and its potential is still attractive to potential buyers, a deal price may have been agreed somewhere between the founders’ projections of future profitability and the new owner’s judgement of the potential of the financial proposition going forwards. Either way, the offer put forward and agreed may involve the founders staying on with the business anywhere between two and five years post-sale in order to retain conduct of revenue generation for the purpose of it hitting certain financial targets which if achieved, will result in the founders receiving additional consideration for the shares they sold in what is known as an earn-out mechanism.   

Earn-outs can potentially be complicated and time consuming to negotiate as the two sides need to reach agreement on key metrics such as the amount and calculation of the earn-out target number itself of course, the payment timetable and length of the earn-out period (i.e. for how long revenue earned post-completion will qualify as contributing towards the earn-out target number) and also the scope of the role that the founders will play in continuing to run the business during the earn-out period and the level of checks and balances placed on them by the new owners during such time.

Whilst both parties will of course, have an overriding shared interest in the on-going success of the business, there is a slightly more nuanced distinction between the agendas of the two sides going forwards that will need to be considered and a position ultimately agreement upon. Clearly, the founders will want to ensure that they are not unfairly prevented in being able to take commercial decisions for the business which will hopefully maximise the potential of their earn-out and equally, they will want to ensure that restrictions are placed on the new owner unreasonably transferring out revenue generating assets for the sole purpose of prejudicing the earn-out numbers.

However, on the other side of the negotiation table, the new owner will want to be protected to ensure that it retains ultimate autonomy over how its new company is being run in a way that reflects its own principles and overall business model and in particular, is set up with a focus on longer term growth prospects over and above any short-termism agenda put in place by founders who are focussed on securing a high value earn-out payment covering the relevant shorter trading period.

Despite the required detail, if both sides are able to take a sensible and commercial approach to discussions around an earn-out arrangement, it can provide an efficient and financially compelling exit platform for founding shareholders who are prepared to remain on board with their business and work with the new owners with the aim of hitting financial performance targets in the immediate future which will of course, be to everyone’s benefit.