How to keep the vendor profitably involved in a business.
If you've acquired a business you may want to keep the founder on by means of an 'earn-out' - a performance-related mechanism designed to keep him or her with the business while new management is introduced.
Earn-outs, popular in the 1980s, got a bad name because they were misused and/or used for too long a time period. Here are things to think about when considering an earn-out structure:
The vendor may 'ring fence' the earn-out - preventing changes to the company. If so, an earn-out is only workable if you're prepared to a) let the vendor run the company; and b) forsake any perceived merger benefits; for the duration of the agreement.
If integrating your business with the acquired firm, it may be possible to run both off a shared overhead base. If so, consider basing the earn-out on a multiple of the increased sales (or gross profit contributions) of the acquired business.
Avoid complexity and putting too much of the purchase price into the earn-out. The simplest method is to pay up to, say, three or four times the excess pre-tax profit above a certain pre-agreed level. An earn-out which is more than half as much again as was paid upfront for the business, may encourage the vendor to inflate short-term profits - at the expense of future ones. Watch out for vendors stopping R&D and marketing expenditure.
An earn-out should last two years at most. Anything longer will delay necessary changes and merger benefits. You should also put in your own senior managers to understudy the vendor and build in a provision for reference to an independent expert in the event of disputes. Stick to these rules and the earn-out should deliver benefits for both you and the vendor.