The Downside of Earnouts In the mid-1980s, a well-known aerospace conglomerate acquired a…

The Downside of Earnouts

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 In the mid-1980s, a well-known aerospace conglomerate
acquired a high-growth systems integration company by paying a huge multiple of
earnings. The purchase price ultimately could become much larger if certain
earnout objectives, including both sales and earnings targets, were achieved
during the 4 years following closing. However, the buyer’s business plan
assumed close cooperation between the two firms, despite holding the system
integrator as a wholly owned but largely autonomous subsidiary. The dramatic
difference in the cultures of the two firms was a major impediment to building
trust and achieving the cooperation necessary to make the acquisition
successful. Years of squabbling over policies and practices tended to delay the
development and implementation of new systems. The absence of new systems made
it difficult to gain market share. Moreover, because the earnout objectives
were partially defined in terms of revenue growth, many of the new customer
contracts added substantial amounts of revenue but could not be completed profitably
under the terms of these contracts. The buyer was slow to introduce new
management into its wholly owned subsidiary for fear of violating the earnout
agreement. Finally, market conditions changed, and what had been the acquired
company’s unique set of skills became commonplace. Eventually, the aerospace
company wrote off most of the purchase price and merged the remaining assets of
the acquired company into one of its other product lines after the earnout
agreement expired.

 Case Study Discussion Questions

 1. Describe conditions under which an earnout might be most
appropriate.

2. In your opinion, are earnouts more appropriate for firms
in certain types of industries than for others? If so, give examples. Explain
your answer.

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