Earn-outs make good sense; disclosures end the mystery

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Agency earn-out deals get a bad rap, impugned as a way to bury liabilities off the balance sheet. But the problem is not earn-outs. The problem (and solution) is disclosure.

The incentive of earn-outs is simple: When Intergalactic Group of Omnivores buys an agency, part of the payout is made in the future based on how the shop performs.

It's short-sighted to dismiss earn-outs as simply buying an agency on the installment plan. When you're buying a company whose key assets are people and business relationships, you should give management an incentive to stick around. Omnicom Group, defending its accounting for acquisitions, noted in a July investor presentation: "Our preferred acquisition structure is an earn-out because it reduces the risk to our shareholders."

The bigger issue is shareholder disclosure, and agency companies this summer moved to do the right thing.

Following the implosions of Enron, WorldCom and Arthur Andersen, agency accounting came under the spotlight. Given that big agency companies grew largely through acquisition, as WorldCom did, it's not surprising. Omnicom stock cratered in June amid questions about accounting; it began to recover after Omnicom expanded disclosures. Interpublic Group of Cos. stock dropped more than $2 billion in value early this month on accounting worries; it rebounded after Interpublic acknowledged accounting errors and issued a broad disclosure. WPP Group, long known for copious disclosure, also expanded what it releases.

It's in agency companies' self-interest to make broad disclosures. It's good for investors-and for agency employees and clients, who also need to know what's up.

So we now know much more about earn-outs. Disclosures show the top three superagencies-Omnicom, Interpublic, WPP-collectively are on the hook for a projected $1.1 billion in cash and stock payments for future earn-outs on past acquisitions. They're also obligated to make additional investments in companies in which they own a stake; that could reach nearly $500 million. The combined $1.6 billion is a big liability.

WPP since 1997 has voluntarily included the cost of projected earn-outs as debt on its balance sheet. Rivals could be forced to do the same if new U.S. accounting rules under discussion end up being adopted. For now, Interpublic and Omnicom disclose estimated earn-out details in a financial footnote. Regardless of what the rules require, they would do well to follow WPP's conservative lead and put the liability on the balance sheet.

Earn-outs are good in principle. More disclosure is great. Now the debate should move to how different companies manage earn-outs. It's big money; Omnicom's estimated $418 million earn-out liability is equivalent to half of the $806 million in long-term debt listed on its balance sheet. Grey Global Group disclosed future obligations of $60 million on past acquisitions-more than its total net income for the past five years. More than half of Grey's liability isn't due till 2005 or later; WPP's commitments to buy additional stakes in WPP-backed ventures extend through 2009. How long is too long? That's worth debating.

If earn-outs are properly structured to pay for performance, they are a good deal for shareholders. Omnicom's chief financial officer, Randy Weisenburger, discussing earn-out liabilities with analysts in June, said "we're very hopeful" earn-out payments down the road will be higher than recent estimates. Why? "The better the companies perform," he said, "the better off we all are."

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