The second way to avoid being burned by an earn-out is to base the payout on metrics you can control.

The metric used to determine the size of the earn-out can vary – it’s negotiable. It could be a financial metrics (e.g., revenue, gross profit, EBITDA, etc.) or an operating metric (e.g., page-views, customers, etc.).

Entrepreneurs need to be sure that the selected metric is one that they can directly influence after the acquisition. For companies that are acquired for their cash flows (probably EBIT in this case) it’s important to base the size of the earn-out on a top line metric, such as revenue. There is good reason for this – the expenses allocated to the target might be very different once the target is integrated into the acquirer. Transfer pricing, overhead expense allocation and new accounting methodologies may drastically alter bottom line figures. As a division of the acquirer, the company’s EBITDA margin might be half of what it was before the acquisition – making it difficult for a management team to meet EBITDA growth targets.

This same logic applies to companies that are acquired before they are generating revenue. If a company is acquired because it generates lots of page-views, but no revenue, management should be wary to base an earn-out on revenue. If these entrepreneurs find themselves stuck using a poor monetization solution (that is mandated by the buyer), the revenue targets may not be in their control. In a case like this, management might only be in direct control over the number of page-views and therefore that’s the target metric that payouts should be based upon.