BUSINESS BLOGS
BUSINESS BLOGS
category: business
22 Oct 2008

Joe the Plumber, meet “Roger the Angel”.

Roger Ehrenberg has some insights into the shifting landscape of VCs and angels.  Some good tidbits.  As the financing landscape changes and becomes more difficult to raise money, I see a lot of young companies being flipped early on.

How does one value such deals?  Read on.

Seeing embryonic - let alone pre-revenue - companies get acquired was all the rage during the go-go Web 2.0 days.  Those days are indeed over.  But quality companies are continuing to be eyed by major media firms.  Traditional media firms have cash on their balance sheets, they don’t like to give up stock (so the fact that their shares are in the toilet is moot) so because expectations have come back down to earth, I think you will see acquisitions, especially with less investments.

With companies where much of the value is in the “forecasts”, it’s not uncommon to look at a deal that calls for an earn-out, according to an M&A executive who has signed many checks in the past decade.   Such earn-out deals provide a semblance of logic to the buyer and can get an entrepreneur the price they want, only that it is paid out later, when some targets and milestones are reached.

These milestones range from very attainable to nearly impossible, and can be measured simply by revenue, traffic, or simply time.

Personally, as an advisor, I tell other entrepreneurs that earn-outs are a necessary evil if you want to sell and lack leverage.  But I also tell them matter-of-factly that once you commit to an earn-out, treat it as bonus, otherwise it’s a recipe for disappointment and becoming disillusioned.

As an entrepreneur myself, I am adverse to them naturally.  But not for the reasons you might think.

The tricky thing with earn-outs is that acquirers have no clue what to do with companies they buy.  As a result, the first year is a wash and the sellers are screwed.  Worst case was dMarc, where a billion dollar deal turned out to be a $102M deal.  That is not bad at all, but everything is relative: if you’re expecting a billion dollar payoff and walk away with a $100M, you are pissed off.  Just ask Bear Stearns shareholders.

I have gone through one M&A where I was a shareholder: when IGN bought AskMen, for example, IGN forgot about us because it was looking to file for an IPO, but then it got bought out by News Corp., and we became the forgotten long lost cousin in some far-off land.

Had that deal been an earnout, the sellers would have been screwed, period, because there was some inaction initially.

There is also the matter of the currency of choice.  Back in April 2006, one company made an overture to acquire my new company WatchMojo.com.  They wanted to offer stock.  Problem?  Their stock is now 90% off what it was then, and although I did not anticipate the severity of the fall, I surely knew that the stock was going to fall.  In cash deals, it is less variable to some extent, but again it all depends on the details.

Personally I am not against earn-outs, provided:

- there is a minimum guarantee that would ensures that the seller won’t hate the buyer,
- the downside variance is offset by enough upside that it’s worth it for the seller to agree to and stick to,
- the buyer commits to X resources, be it time, people, money etc. OR alternatively, autonomy to run the shop as you see fit.

Ultimately, it boils down to leverage.  Once you start asking for this, and getting it, then it means you can avoid the earn-out talk altogether and adopt a time-tested method of negotiating: