Not bad for a startup

agaveLast week marked the announcement that Diageo was acquiring the Casamigos tequila brand for a cool $1 billion.  This is a sexy price.

And of course the announcement was made sexier by the fact that Casamigos was founded just four short years ago – so this is a significant payday in the life of what is essentially a startup.

But the sexiness doesn’t stop there.  Because as those who follow the industry already know, Casamigos was founded by the trio of George Clooney, Rande Gerber and Mike Meldman.  Mr. Clooney is, of course well known for his roles in film and television (although in fairness it seems to me that his most impressive feat may be convincing Amal Alamuddin to become Mrs. Clooney – her legal resume is nothing short of extraordinary; the one thing Mr. Clooney and I seem to have in common is that both of us married up).

Neither Mr. Gerber nor Mr. Meldman are names with the same level of Hollywood flair. But these gentlemen are just as well connected as Mr. Clooney.  As Ms. Alamuddin is now known as Mrs. Clooney, perhaps Mr. Gerber should now be known as Mr. Crawford.  His spouse – Cindy Crawford – essentially invented the concept of being a supermodel – pouring gasoline on the already smoldering adolescent dreams of many young men – and I suspect more than a few young women – of my generation.  And Mr. Meldman, as the founder of Discovery Land Company, has developed 19 luxury resorts and communities around the world.  In short, Mr. Clooney, Mr. Crawford (sorry – couldn’t resist) and Mr. Meldman are heavy hitters in the world of business.

So it shouldn’t surprise anyone that by putting their resources and connections to work they could grow the Casamigos brand by about a 54% compound annual growth rate over the last two years.

Throughout the press coverage related to the transaction there have been a number of articles suggesting that Diageo may have overpaid.  And indeed Diageo’s stock did fall a bit immediately after the announcement of the deal – suggesting that the market may think that Diageo got carried away.  But I’d like to ask a different question.

Why would the parties agree to this structure for the deal?

Under the terms as we understand them, 30% of the purchase price (i.e., $300 million) is going to be paid – if at all – in an earn-out over the next 10 years.  In real terms, this means that the purchase price for the brand is not the $1 billion that made the headlines. Rather, the purchase price is something between the $700 million being paid up front and the $1 billion potential.  And you can bet that once Diageo is at the helm, there will be opportunities to ensure that the actual purchase price is less than that total payment.

This isn’t intended to ascribe any malice to Diageo.  Nor is it intended to assert that Diageo will seek to limit the success of the brand – which is presumably the primary driver behind how much of the earn-out will actually be paid. But it is a simple recognition of the fact that when it comes to earn-outs, the motivations of a buyer and a seller are not always perfectly aligned.

In this case, Diageo’s primary incentive should be to make sure that Casamigos is so astonishingly successful over the next 10 years that it becomes obligated to pay the full amount of the earn-out but that extra $300 million becomes insignificant.  But suppose – just for the sake of argument – that Casamigos doesn’t maintain its hockey stick growth rate and looks instead to be on pace to eke out just enough growth to hit the minimum payout thresholds on the earn-out (whatever those may be).  In such a situation, Diageo may actually have an incentive to depress the growth of the brand and save itself some cash.

And, of course, the Sellers’ incentives are occasionally conflicted as well.  Here, they have every incentive to push the brand to meet the performance metrics that will ensure the $300 million payout, but little incentive to do anything beyond that.  The success of the brand to date (including its stratospheric growth) has depended – at least in part – on the celebrity status of its owners.  So do we think that Diageo will see a continuation of Casamigos’ level of growth if the performance targets are met and Mr. Clooney and crew (but especially Mr. Clooney) stop being the faces of the brand?  Alternatively, do we think that Diageo will find itself needing to write another check to the three amigos to keep them involved in promoting the brand?

These sorts of issues are the reason that I – to put it bluntly – really dislike earn-out structures.  At best, they are an opportunity for a buyer and seller to compromise when they can’t agree up front on the value of an asset.  At worst, however, they are an opportunity to misalign incentives among the parties create an opportunity to fight later on in the parties’ relationship.  In the middle, they create a structure where the continued efforts of the Seller are to be used to continue to push the business forward. My guess is that the Casamigos situation is an example of this middle path.  Diageo recognized that it needed Mr. Clooney (and perhaps to a lesser extent Mr. Meldman and Mr. Gerber) to stay involved in order to achieve the results it wanted for the brand.

In most situations, a better option (if available) is to try to find an acceptable all-in price now and – if necessary – to supplement the deal with other incentives for personal involvement  This option is almost always available.  In the Casamigos case, who knows what an all-in price might have been.  It might have been startlingly close to the $700 million up front payment actually agreed to, if Mr. Clooney had been willing to sign on to continue to promote the brand for some period of time.

But of course that would mean that the extra payment might have been earned by Mr. Clooney and not shared with Mr. Gerber or Mr. Meldman.  Could it be that simply isn’t the way Mr. Clooney wants to treat his amigos?

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