For Paul Stillmank, former CEO of 7Summits, a company he sold to IBM, earn out is a dirty word.
"I have some teenage kids at home, so I always tell them not to use a four-letter word," Stillmank said at the Milwaukee Smart Business Dealmakers Conference. "I consider the earn out a seven-letter word, and don't want to really hear that word. I did not have to do one. It gets down to how competitive your selling process is, and the scarcity of what you're doing in the market, if you don't want that structure."
Earn outs are arrangements between seller principals and the buyer that are designed to retain principal expertise, share risks, and sometimes shift tax impacts for interested parties. It's essentially a way to share some of the risk, allow for some upside and help sellers to get their price.
It can be a good tool, he says, and he's seen it used well. When he was a company principal, he bought a company and held out to get the contribution margin in the door and then negotiated through an earn out to give it to the incoming leadership as they continue to perform.
While it can be an effective tool, it's not always necessary.
"If you're an owner, try to get all your dollars out," he says. "You don't want to leave stuff hung up because things can happen, like, I don't know, a global pandemic."
Given that his company was in a highly competitive market, earn outs were not considered as part of any offer. The company built purpose-driven, pre-built communities for business, for customer networks, for partner networks, for employee networks, and then eventually started to verticalize that for different Industries. Large enterprises used the formulation the company created, making his business a must-have acquisition.
"There were companies coming with earn out in the first round of people who put their bid forward and said, here's our initial indication of interest," he says. "But those that had known us and studied them in the market separated themselves by just not doing it. And that field was large enough that we never had negotiate away that element. And IBM in particular, who ended up buying us, wanted to differentiate themselves in the process. So they actually brought an all-cash at closing situation, and then created incentives to maintain my management team and myself in place for some period of time until the business was integrated."
One of the important things he says he's learned is raising up the value of the shares for the shareholders and what drives that is revenue and profit.
"So, most earn outs are going to say, are you going to maintain that revenue growth? And you could talk about contribution margin or gross margin, because a lot of funny math happens when you get down to net margins when you sell your business, but really it's going to be some revenue and profit growth trajectory that's being incented. And then as you hit some margin of error, plus or minus of that, that's going to trigger things to create the payouts for the owners that sold that business to say, we're still within some band of performance. But to me, it's got to be revenue and profit growth. For us, we would have called that EBITDA or net margin. But at the end of the day, in big transactions, it's going to be gross margin or contribution margin because you're going to have other expenses that come in with a big company and that's a fair way of measuring that you're still performing. I don't believe in saying, did you get high customer retention again, because maybe in your business it is, but for what we're doing, especially with a big strategic, that's the go-to-market. IBM is going to be less interested in some of the low and midmarket companies and you might plan to shed them as part of that. So, it's really just can we continue to grow revenue and profits at a pretty close to the same pace as pre-transaction?"
