Deal Structures Today: Stock Options & Earnouts
Timothy Goddard
Great, thanks, Ward. Now let’s look at exploring stock options in particular with Corum VP Jeff Brown.
Jeff Brown
After we’ve negotiated the buyer to his limit on cash valuation, buyers and sellers may still differ. So we need to bridge the gap. That’s when stock options can be helpful. Options rewards performance inducing sellers to stay on board and aligned after the deal.
For buyers, options are cheaper than cash. This is especially true for high growth buyers keen to preserve cash. The value of options can be tough to know in advance. So don’t let too much of the deal get tied to them and make sure you can meet those targets. Rely on simple, clean metrics like gross revenue instead of profit for vesting triggers. For options to be valuable, you need a way to be liquid, so be sure your buyer has a plan to sell, IPO or buy them back at a later time.
Here are two deal examples from my portfolio.
For the first example, in addition to cash, the founders received options at a low strike price that vested each year over the next 4 years as performance bonuses, adding another 15% to the deal value.
In the second, the buyer, a $1B company with IPO aspirations held the seller’s company as a wholly owned subsidiary carving out 20% of the equity for the two seller with options for another 5% if first year performance targets were reached.
Timothy Goddard
Thank you, Jeff. We’ve alluded to it, but now let’s dig deeper into the question of earnouts with Rob Schram again.
Rob Schram
Earnouts help buyers and sellers “bridge the gap,” tying upside to specified goals like product releases, new customers, revenue, or profitability, either over years or at one time. This is especially applicable when the seller projects aggressive financials for improved valuation, but can also serve as a “sweetener” to help keep key people in the company post-closing.
I recently concluded a sell-side engagement that added a valuable new dimension to the buyer’s offering, but included an absolute requirement that the founder stay on to head up the new division. The earnout package, paid out over multiple years, included cash, restricted stock and incentive bonuses. As with this case, it’s always important to contractually secure the authority and resources to meet the earnout criteria; and for this reason, profitability isn’t a recommended benchmark.
If the base price falls within an acceptable range, earnout can be “frosting on the cake” - especially if there is good opportunity for future growth and accelerators for performance over target. Properly executed, sellers can earn significantly more from a sale including earnout—but given the risks, we generally recommend that earnout not exceed 25% of the consideration.
This is a segment from Deal Structures Today (September 2014) webcast. For more information, please visit Corum Group's Software M&A Webcast Archive.