Why multiyear earnouts can cause problems

If you're considering selling your practice or firm to another advisory firm, think twice before agreeing to any long-term earnouts.

An earnout is an incentive for an acquired firm to deliver on some agreed-upon result. Some earnouts are straightforward, such as a requirement that, say, 95% of clients remain with the acquiring firm for a year. This type of earnout aligns interests. The buyer wants to make certain the clients stick, and the seller has a financial incentive to make sure the clients are pleased with the new structure.

But what I’ve recently noticed is that not only are earnouts becoming more complex, and their durations longer, they are increasingly structured in ways that leave the interests of the buyers and sellers misaligned.

One common earnout is designed to incentivize a seller to continue to grow its business or practice for several years after the transaction.

Here’s an example: A practice has a purchase price of $1 million. The seller receives that in the form of cash or a combination of cash and equity; there's also a three-year earnout that will pay the seller an additional $300,000 if certain client, asset, revenue and profitability goals are achieved.

This all sounds fine on paper. But for firms that want quality relationships with partners and employees, long-term earnouts can be highly divisive.

Here are just a few of the problems.

The selling firm carries responsibility but no authority. When a firm sells to another firm, that firm gives up control and along with that, the authority to manage their practice as they’d like. The earnout provides a financial incentive to grow, but without the authority to do things such as increase marketing, hire additional staff or upgrade technology. The seller is left with the responsibility of delivering results without any power or control.

The selling firm must fight for resources. To achieve the earnout, the selling firm will try to get as many resources as possible without incurring any costs. They’ll want the parent company to help with tasks such as IT, human resources, trading and more, but they won’t really care about what it means to the parent company. And they won’t want to pay for these services. This misalignment of interests can create tense conversations and can be detrimental to relationships and success.

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The acquirer will have an incentive to saddle the new firm with costs. The acquiring firm would obviously like to see the practice grow, but it would prefer not to pay for it. Allocating a higher percentage of operating costs to the acquired firm reduces profitability and in the process, reduces the earnout that must be paid.

I’ve personally been a seller with a large earnout, and it was an awful experience. We sold a mortgage company to a Fortune 500 company and a good chunk of our payment was in the form of an earnout over a two-year period. Once the transaction closed, the Fortune 500 company changed the business so drastically that it was impossible for the company to hit its targets. It created a great deal of tension and did not end well.

If you're selling your advisory practice (as so many principals are), always strive to align interests with the buyer to the same extent you strive for alignment with your clients.

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Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA with $13 billion in AUM.