Mitigate Gatekeeper Risk

One risk that can scare off investors is the presence of gatekeepers in critical parts of the supply chain.  By "gatekeeper" I'm referring to a person or company that can prevent your business from obtaining access to resources that your business is dependent on.  If you need another party's permission to obtain access to key resources (e.g., distribution), your company faces the risk that it will not have access to those resources (the gatekeeper might say 'no') or that it will be charged a heavy toll in order to access them.

One classic example of gatekeepers existed in the mobile industry in the days before Apple opened up the iPhone platform to developers.  In 2007 and before, many entrepreneurs creating applications for mobile phones needed the permission of Verizon, AT&T or a few others in order to launch their companies.  Without the approval of these giants many of these entrepreneurs couldn't deliver their products to consumers.  Those that received permission paid a high price for access to their mobile networks since Verizon and AT&T had significant negotiating leverage.

It's worth noting that concentration in the tier of the supply chain that has the gatekeepers generally increases risk.  When there are fewer gatekeepers it's less likely that entrepreneurs will get the deal that they want, as 1) the entrepreneur simply has fewer chances to close the deal and 2) gatekeepers that face less competition are less motivated to take risks and new businesses or new ideas. 

Fragmented tiers of a supply chain can also create gatekeeper problems for entrepreneurs.  If competitive pressures are limited, gatekeepers may not explore new opportunities and may negotiate aggressively on pricing and terms.  The gatekeeper issue in un-fragmented markets can be especially problematic for companies that threaten the status quo of gatekeeper's marketplace.

The gatekeeper issue is one that investors pay a decent bit of attention to.  There are, however, ways to mitigate this.  The first way is to cut out the partners that you might have been dependent upon.  If your gatekeepers played a key role in distribution, sales or marketing, this might mean selling your product directly.  For example, in the days of the closed mobile platform some companies sought to distribute their product over the mobile web, alleviating their need for partnerships with Verizon and AT&T.  The other, slightly more obvious way, is to secure gatekeeper partnerships early-on before you invest much time in your company or seek to raise capital.

The more your company depends on partnerships the more calculating you should be thinking about how to mitigate the gatekeeper risk for your business.

Earn-Outs Should Only Be Upside

In my series of post on avoiding being burned by an earn-out, I discuss how the entrepreneur can protect himself in the event of an earn-out. Similar tactics are relevant for VCs: base the payout on simple and controllable metrics, ensure the company has sufficient resources and keep the earn-out based on short time-frames.

The single best way to avoid being burned by an earn-out is to ensure that the upfront portion of the deal (which is not subject to future performance) is, in itself, a sufficient exit for all parties. The earn-out should be upside in the deal, not the majority of the deal itself.

In reality, securing such a structure is often easier said than done, depending on the negotiating position of the seller. Even so, achieving this goal should be an important objective in the negotiation – ensure that the immediate transaction is sufficient so that if the earn-out doesn’t meet expectations the VCs and entrepreneurs still end up doing well.

Why VCs Don't Like Earn-Outs

In my recent posts on the subject of earn-outs, I focus on how to avoid being burned by these structures. Another important part of the story is that VCs try to avoid these structures altogether. Here’s why:

• No Control Over Performance: While VCs don’t operate the startups that they invest in (entrepreneurs and hired managers do), they have the option to be actively involved as an advisor through board representation. When a portfolio company is acquired, VCs have even less of an ability to influence the direction of the company. Essentially, VCs are displaced by the management of the acquirer.
  
  As a result, VCs are adverse to earn-outs since they don’t want to have their returns impacted by factors outside of their control.


• Averse To Being Subject To Whims Of Large Corporations: The decision making at large corporations is often highly complex, reflecting a web of considerations that range from personal political agendas to shareholder biases. On any given day a new promotion or a shift in the stock market can start to shift the momentum of the organization in a new direction – a direction that may have an adverse impact on an earn-out. As I mentioned in prior posts, the whims of corporations can change resource allocation relatively quickly, devastating a newly acquired company’s plans for growth.
  
  This complex decision making process is concerning to VCs as a change in tide can destroy the likely pay-out for investors.

Keep The Earn-Out Period Short

The fourth way to avoid being burned by an earn-out is to keep the earn-out period short.

It’s important for entrepreneurs to negotiate hard to limit the length of time under which the earn-out metrics are evaluated. There are two key reasons for this: external and internal changes.

First, exogenous factors can limit an entrepreneur’s ability to maximize their payout. If the economy falls into a recession during the earn-out, revenue targets might not be as viable. The longer the earn-out period, the more risk the entrepreneur is taking.

Second, as more time passes the odds of the buyer’s strategy changing increase. While leveraging your company may have been a strategic imperative when it was acquired, market dynamics may dictate a different strategy post-acquisition. Or, perhaps, a new management team was brought into run your acquirer. Either of these factors (and many others) could lead to a change in priorities which could leave your business last in line to receive capital, support or other mission-critical resources.

In sum, it is advantageous for entrepreneurs to minimize the length of the earn-out (so long as they have sufficient time to meet their earn-out benchmarks).

Ensure Access To Sufficient Resources

The third way to avoid being burned by an earn-out is to ensure that you have access to sufficient resources.

Imagine it’s the day after you inked the sale of your company. Much of your pay-out is based upon meeting revenue targets in the coming quarters, but you’re confident that you’ll meet the revenue targets – managing this business is as easy as turning a crank at this point. You’re on cloud nine. That is, until you check your voicemail. The second message is from the CEO of the buying company, your new boss. He notifies you that your marketing budget has just been cut in half as part of a cost cutting exercise. You know that it is now impossible to meet the revenue growth targets outlined in the earn-out – you’re not going to be able to maximize your pay-out. You just sold your company at a discount.

Scary scenario? You bet. Here’s another.

You are two months into the agreed upon one year employment at the buyer’s company. You have been instrumental in ensuring that your company, now a division of the mother-ship, is hitting its numbers. With close monitoring, you’re confident you’ll get the rest of your payout.

After getting settled into your office for the day you head over to the CEO’s surprise strategy meeting, where he introduces a new product line that he feels you would be perfect to run (since you’re the only person in the company that has built anything in that sector). Aware of your commitment to your division he asks you to split your time – allocating 50% of your attention to the new product line. You leave the meeting trying to find a way to reposition yourself, as you’re worried that your division won’t perform enough to meet the earn-out benchmarks without your full attention.

While it’s impossible to layout all of the details around the resources (staff, capital and your own time) you’ll need when you enter into an earn-out, you should try to obtain agreement from the buyer about your resource availability and you should have your lawyers bake in some language that can protect you.

You should also try to create a formal mechanism for increasing your resources as needed. If market dynamics change, market rates for key resources change or unique opportunities present themselves, you need to be able to take advantage of those changes. Incentives should be aligned; it’s bad for everyone if the company stifles your business’ growth just to minimize your earn-out. Having a pre-defined process for making these adjustments can help along the way. One approach is to have a formal quarterly review of your resource allocation that includes all of the appropriate people.

Base The Earn-Out On Metrics You Can Control

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.

Base The Earn-Out On Simple Metrics

The first way to avoid being burned by an earn-out is to base the payout on simple metrics.

Earn-outs are most effective when the size of the payout is determined based upon one or two simple variables. For example, higher revenue might lead to a higher payout to the shareholders of the acquired company.

In contrast, imagine an earn-out based upon price changes, customer acquisition cost and customer retention. To complicate matters, these variables might be woven together in an arbitrary equation that provides each metric with a weighting. In pursuit of maximizing the payout, management might focus on trying to optimize too many variables in the business, potentially resulting both in management not focusing on what matters most to the buyer and making it difficult for management to maximize their payouts.

Simplicity provides incentive alignment, clear objectives and less room for argument when it comes time to sign the check.

How To Avoid Being Burned By An Earn-Out

In my recent post, Earn-Outs: Distributing Risk, I provide a high-level description of how an earn-out works. While in they are quite simple, these structures can make it difficult for unprepared entrepreneurs to get their fair payouts.

One of my mentors, Jed Katz, has lots of his experience as both an operator and investor. During his time as an entrepreneur, he learned a few tactics that can help entrepreneurs increase their chances of maximizing their payouts.

I'll cover the the top-four ways to avoid being burned by an earn-out in the ensuing posts.

1. Base Earn-Outs On Simple Metrics
2. Base Earn-Outs On Metrics You Can Control
3. Ensure Access To Resources
4. Keep The Earn-Out Period Short

Why Employees Receive Common Stock

 When employees are granted stock, or more often stock options, they are entitled to shares of common stock. Common stock offers employees access to the economic benefits of ownership, aligning incentives to focus on increasing the value of the company.

It’s worth noting that these option plans do not provide employees with preferred stock for several key reasons.

First, preferred stock is designed to offer its holders unique control over specific aspects of corporate decisions (e.g., sale of the company, compensation of senior executives, etc.). These aren’t decisions that employees are in a position to make as they aren’t always privy to all of the information required to make these decisions.

Second, investors seek preferred stock because it enables them to make the aforementioned decisions. When those decisions need to be made a vote is taken amongst the holders of preferred stock. By giving employees preferred stock investors would own a smaller percentage of the total pool of preferred stock, reducing their ability to control these votes. As a result, the distribution of preferred stock would prevent investors from providing the company with capital.

In sum, employees are granted common stock because it is designed to offer them the incentive to exclusively focus on expanding the value of the company.

Keep Your Cap Table Simple

As I mentioned in my post, How A VC Can Change The Cap Table, VCs go through a re-balancing act when they propose a new cap table.  This can be a complicated juggling act as the VC needs to ensure both that all (or most) parties in the transaction are satisfied with the outcome and that the new cap table provides sufficient incentive alignment for key executives.

The most sophisticated entrepreneurs understand the potential complexities of this process and make decisions early in the life of the company that keep their cap tables simple to ensure that viable structures can be realized.

In order to keep cap tables simple before taking VC money, entrepreneurs should try to:

• Only issue common stock (with no special rights),
• Minimize the number of shareholders, and
• Ensure that key managers retain a significant share of the common stock.

Entrepreneurs are sometimes forced to make decisions that sacrifice some of these principles – this can be a necessary evil for building the business.  However, being aware of these considerations can ease the process of acquiring a VC investment.