How Earnouts are Costing Huron its CEO, CFO and CAO

Earnouts are those interesting residual matters that pop up in some acquisitions. An earnout exists to provide a transition period between some of the acquired firm’s owners and the new owner/management team. Earnouts are certainly valuable for an acquirer when there are key persons in the acquired organization who can make/break the company. Acquirers want to lock up this key talent for some time so that the financial performance of the acquired firm doesn’t suffer and key knowledge/skills can be transitioned.

In deal after deal that I’ve advised, I caution my clients who are selling their firm against earnouts. I understand why the acquirer likes them but they can be quite costly to those being acquired. How? Well, when your firm is acquired, your earnout might consist of these terms:

- you get 70% of the purchase price now - the remainder is paid out at 10%/year for the next three years based on your ability to achieve specific financial, operational or other targets

My issue with earnouts is how the earned portion is calculated. If the acquirer ties these payments to the profits derived from the acquired business, they can stuff all kinds of costs into the acquired firm and ensure that it never makes a profit. They could also kill off the acquired firm’s products so that it can’t make any revenue let alone a profit. Don’t laugh as that does happen whenever a competitor wants to get rid of a competing product. Once a firm is acquired, the acquired firm can no longer control the financials, the performance metrics, etc. This is why I don’t recommend earnouts.

Huron Consulting Group must restate a little over three years of its financial statements. If I read their press release correctly, they have to do so as some of the people involved in recent acquisitions were apparently getting compensated post-deal close even though they weren’t shareholders. This sounds like non-equity persons were given an earnout or override to stick around and deliver revenue. Here – let’s see the exact wording:

The restatement relates to four businesses that the Company acquired between 2005 and 2007 (the “Acquired Businesses”). Pursuant to the purchase agreements for each of these acquisitions, payments were made by the Company to the selling shareholders upon closing of the transaction and also, in some cases, upon the Acquired Businesses achieving specific financial performance targets over a number of years (“earn-outs”). These payments are collectively referred to as “acquisition-related payments.”

It recently came to the attention of the Audit Committee of the Board of Directors that, in connection with one of these acquisitions, the selling shareholders had an agreement among themselves to reallocate a portion of the earn-out payments to an employee of the Company who was not a selling shareholder. Following this discovery, the Audit Committee commenced an inquiry into the relevant facts and circumstances of all of the Company’s prior acquisitions to determine if similar situations existed. The Audit Committee engaged legal and financial advisors to assist it with the inquiry and notified the Company’s independent auditors who had not previously been aware of the Shareholder and Employee Payments described below.

This inquiry resulted in the discovery that the selling shareholders of the Acquired Businesses:

1) Redistributed portions of their acquisition-related payments among themselves in amounts that were not consistent with their ownership percentages (“Shareholder Payments”) at the date of acquisition by Huron. Such payments were dependent, in part, on continuing employment with Huron or on the achievement of personal performance measures; or

2) Redistributed portions of their acquisition-related payments to certain Company employees (“Employee Payments”) who were not selling shareholders of the Acquired Businesses. Such payments were dependent on continuing employment with Huron or on the achievement of personal performance measures.

This earnout issue is causing the CEO, CAO and CFO of Huron to fall on their swords. Each is resigning from the firm. Reuters is reporting that Huron’s stock price fell by about half in after hours trading Friday.

Huron, it should be noted, is chock full of Arthur Andersen escapees. Huron is not an accounting or auditing firm. Nonetheless, this event will doubtlessly cast a cloud on its ability to sell work. How long this lasts will be a great water cooler discussion item for a while.