Retention Agreements & Earnouts
Phil described that he was tied to Deloitte for a period of time after his acquisition was finalized. Maria Giudice also described that a material amount of the money she made on the sale was contingent on her post-sale activities; Maria and a large portion of her team had to stay employed at Facebook for a specific amount of time, or she would forfeit cash (and she did!).
These types of requirements or, as they are sometimes called, handcuffs, are common in sale agreements. The reason is because, from the buyer’s perspective, they are buying you: your ideas, your processes, your ability to lead, your tacit knowledge of the business, and your relationship with your clients and your team. If you leave, their acquisition becomes much riskier and, consequently, less valuable. Financial upside is a way to attract you to the deal. Retention agreements are a way to keep you after the deal is closed.
There are a few primary types of retention agreements that you may encounter. These typically tie money to the amount of time you stay, the amount of revenue you bring in, and the amount of your team that sticks around.
Money tied to the amount of time you stay
Often, an “earnout” is paid at the end of each year, over a period of time (typically 2–4 years). Sometimes that money is paid in progressively larger amounts, encouraging you to stay even after the initial glow of the deal wears off. Staying in a job feels pretty easy in the theoretical, but then the specifics kick in, which will try your patience:
- Maria was marginalized, stuck in a Director role, and ran into a culture clash that was insurmountable for her to manage
- Gavin found himself encountering corporate financial constraints he didn’t expect
- Debre experienced an abusive environment
- Christian became responsible for internal IT system rollouts that were culturally contentious (and boring!)
In normal situations, you might quit jobs like these right away. But if millions are on the table, you might change your mind, even if you aren’t happy. There’s no way you can predict the future, but you can do your own cultural diligence by spending as much time as you can with the potential buyer before agreeing to terms. Can you find out the real gossip and real cultural highs and lows? Can you make an objective decision, rather than an emotional one, about how you may respond to this form of agreement?
Money tied to the amount of revenue you generate
The most typical form of retention agreement is based on your ability to keep doing what you were doing before—making money selling creative services. You would think that this is pretty clear; when you sign a new contract, the amount of the contract is added to your running revenue tally, and at the end of the retention term, you either made it or you didn’t. But there are intricacies to revenue generation to consider.
In your agency—particularly if it was small—it was probably very clear who closed a deal. In fact, for some of the people I spoke with, they were the only ones selling, so it was very black and white. But larger deals in larger organizations have many people participating in the business development process. Phil described a complex formula used to identify how signed revenue was allocated to the sales team. Things become subjective, quickly.
Revenue recognition also gets more complicated to track and manage, because you’ll lose visibility into the financial processes of a large organization. It’s rare that your acquirer will work on a cash basis, but if they do, you may not have any view into accounts receivable for some time, because you aren’t the one depositing the check anymore!
And we’ve all experienced the end-of-year crunch, when use-it-or-lose-it money becomes available from clients, but revenue targets loom. If you understand how you’re tracking to a target, you might find some new enthusiasm to go the extra mile in a sale. But if the tracking is delayed, and you won’t know where you stand until March or April of next year, it will become a shot in the dark.
Money tied to the amount of your team that sticks around
In an acqui-hire, the value of your company is in the people, and if the people leave, there would have been no reason for the buyer to buy the company in the first place. It would be advantageous to them to give you ways to encourage your team to stay, like discretionary funds for bonuses or cool pro-bono projects to work on. But it’s rare that the buyer will do that, because they’ll expect you to already have a strong relationship and rapport with your team.
If you tie your personal sale rewards to the retention of your team, you’ll need to be really confident that you can keep people happy and challenged. One way to do this is to negotiate for a management carveout—to pass down the retention/reward to your team, and tie their bonuses to retention. But designers aren’t always financially motivated, and so you may find yourself with few levers to pull when your team begins shying away from a new corporate culture or new types of project work. And that carveout may come out of your share of the money, meaning your overall take-home is materially less than you thought.
Playing out the doom and gloom
The situations above seem bleak. When you are negotiating any of these retention agreements, it becomes important to play out potential “what-if” scenarios in very clear, crisp and detailed language in your contract. These are real possibilities; as I spoke with founders, I heard stories about every single one of these examples. Give these scenarios real attention and contemplation, and then have your lawyer add explicit language to your contract related to each one.
What if you are fired with cause before your retention agreement is over?
“Cause” can be complicated, but imagine that you do something wrong—either something clearly indicative of poor judgment and incompetence, or something that can be described as poor performance. Do you get your earnout? What if you are in the process of being terminated, perhaps through a performance plan to be “managed out” when your earnout time period is up. Can they claw the money back after you’ve been let go?
What if you are fired without cause (perhaps through a layoff or reorganization)?
Large companies make changes all the time. What if the company makes a change that cuts your team, or you? Does this accelerate your earnout, or does the money disappear? Is it prorated based on when that layoff happens?
What if you are moved into a role that isn’t a fit? What if you are marginalized, either on purpose or by mistake? And what if you get a new boss who sucks?
There are lots of passive-aggressive ways to kick someone out of an organization without firing them. In the movie Office Space, Milton is moved into the basement, without his red stapler. You’ll hear later from Max Burton that, after selling his company Matter to Accenture, he suddenly found himself flying 100,000 miles each year to make his earnout numbers. Would that be enough for you to leave? And if you do, will you be walking away from your earnout?
What if you disagree with how revenue recognition is allocated?
If your money is tied to your ability to sell and close deals, a large amount of subjectivity is introduced into the process. I spoke with someone who sold his company to a very large IT integrator. After the sale, he would be brought into a large business development opportunity to run a creative workshop, get the potential client excited, and help them see the power of innovation and creativity. The multimillion-dollar sale would close, and he would be given credit for a tiny, tiny fraction of the deal’s revenue, because it was perceived that he worked less on the deal. Is that fair? And if not, what’s your ability to challenge the allocation?
A big challenge around revenue recognition comes at the end of the year. Imagine it’s December and you have a target to hit by the end of the fiscal year. You deliver on the 15th of the month, everyone goes on vacation, and in the new year, you make some small changes at the request of the client. Can you recognize the revenue tied to that deliverable? What if your earnout is really close, and that deal will kick you over the edge?
What if your team is fired?
Imagine that your earnout is tied to retention of your team; a percentage of the team needs to stay for a certain amount of time. What happens if the company decides to do a round of layoffs? What if your new boss doesn’t gel with some key members of the team?
Make it explicit
Each of these scenarios, while not likely, are also not impossible to imagine. The way to mitigate these is to answer the question posed above, very explicitly, in the contract. Define what revenue recognition means and how it’s calculated in excruciating detail. Work through what types of events accelerate your earnout, and pay particular attention to those events that are typical of larger companies (often related to layoffs, reorgs, and political infighting). Be sure you understand exactly what you have to do in order to make the money you’ve negotiated for. Don’t take it for granted that everyone is using the same language and has the same understanding of the if/then terms. And most importantly, realize that anything and everything is negotiable. If your earnout feels tied to something out of your control, push back on it!
