May 16, 2022
Earnouts in a Business Sale
Mitchell is a content strategist and creative content editor, specializing in financial copy and travel writing. He has experience working for Citi as a head creative writer, LendingTree as an editor, and Investopedia as an editor.
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There will be times when selling a company outright won’t be realistic. The concept of “selling your business” often means much more than the buyer cutting the check and the seller handing over the keys.
The intricacies of a sale become most prevalent when a prospective buyer and seller arrive at what they consider a fair purchase price for the target company—with a large valuation gap between them. Closing the deal will require selecting the correct instrument, and this is where earnouts are most commonly seen.
In their most basic form, an earnout in a business sale occurs when a seller finds their valuation higher than the buyer’s, who cannot or will not concede the difference in order to make the full upfront payment. The amount in contention (the gap between valuations) is instead paid to the seller over time and is usually triggered by hitting specific performance goals.
How Earnouts are Structured
Valuations are somewhat of an art, especially when small businesses are concerned. You aren’t able to determine the price of a private company in the same way you would a publicly traded one, where the open market assigns value via share price, and the company is constantly being evaluated by third-party rating agencies like Moody’s or Morningstar. When it comes to arriving at a fair value for your small business, a reputable business broker is essential.
When selling a business, there are a number of key considerations that are fundamental when structuring earnouts:
Ensuring that the performance targets are realistic.
Not tying themselves to a single performance metric (such as gross profit).
Applying non-financial considerations, like time equity and opportunity loss, to the earnout amount.
Taking the lion’s share of the business sale in outright cash.
Agreeing on which accounting principles to apply to the deal, usually GAAP (generally accepted accounting principles).
Ensuring buyer transparency during the earnout period, especially pertaining to financial records.
As you can see in the list above, earnouts are not based on a line item you’ll find in a financial dictionary and are highly subjective when it comes to the terms of the deal. Accounting principles such as EBITDA, revenue, units sold, and profit growth are easy to compile in hindsight but less clear on how to apply them going forward when structuring an earnout deal. Revenue is by far the cleanest metric to use and is resilient to creative accounting. A close relative but much more easily adjusted financial metric would be net income, which is subject to “inconsistencies” when calculating items such as depreciation.
The financial aspects of an earn-out deal will most likely be easier than hammering out details with the acquirer such as how long the earn-out deal will continue, if there are bonus tiers, and how much control the seller will retain once the deal is inked.
However, because the seller’s earn-out amount is tied to their performance, maintaining the greatest amount of control over the acquired company’s operations, especially those that are directly tied to the earn-out provision’s cash flow or other financial markers, is of paramount importance.
In no way is this article meant to dissuade either party from considering an earn-out provision. In many cases, it can be the bridge between buyers and sellers who otherwise cannot agree on a purchase price. The particulars of an earn-out structure are items that are best discussed with a business broker, rather than relying on your personal negotiation skills. This is especially prudent when the buyer is financially articulate or is a private equity firm well-versed in mergers & acquisitions (M&A deals).
Earn-Out Payments and Future Performance
Earn-out agreements are highly dependent on both parties' willingness to negotiate and their skill in doing so. From a seller’s perspective, they should structure the deal to achieve two main goals post-acquisition: they receive the highest percentage of the deal as an outright payout, and the financial performance indicators they need to hit are not only possible but probable.
The payment structuring for each deal post-closing is unique, but common earn-out percentages are between 15 and 50 percent of the sale price. Obviously, the higher the percentage, the lower the initial deposit and the higher the earnout payment. Typical time periods range between one year and five years. Both buyers and sellers are usually interested in wrapping things up and moving forward sooner rather than later, especially if the business is growing at the forecasted rates.
Sellers need to recognize that as long as the performance targets are achievable, they can afford a slipup or two while managing the business post-sale if the deal is structured on an extended time horizon. If the earnout payment total amount is $500,000 divided over 16 financial quarters, that equals a possible payment of $31,250 each quarter.
Assuming the seller, who is now managing the business as much as possible, achieves their target every quarter, after four years (16 quarters), they will have been paid $500,000. This is the best-case scenario. If a seller falls short of a performance benchmark a few times, they will miss the payment. However, since it is stretched out over 16 quarters, they have ample time to correct errors or increase business. If there is a bonus incentive where the seller is able to make back that payment by overdelivering in a future quarter, that’s an exceptional benefit.
The flip side of this is taking payments over a much shorter time period, say two years. Instead of the $31,250 each quarter, your payment amount would be $62,500. Missing a mark in the shorter timeframe not only means a higher percentage of the earn-out payment is forfeit, but there is less time to correct the issue. This is only one of many common mistakes people make when selling a business, but one that thankfully can be negotiated before signing.
If a seller can afford to delay the payments and are not concerned with inflationary pressures of other outside influences, it might be worthwhile to consider taking a longer payment period.
Advantages and Disadvantages of Earn Outs
For a seller, the most obvious advantage is that an earn-out can help close a deal that would otherwise fall through. You typically see earn outs occurring in businesses that are highly dependent on the skill-set of the seller and the buyer wants to ensure a smooth transition, the buyer is not able to bring the full seller valuation to the table, the buyer and seller disagree on valuations, and either the buyer or the seller has personal reasons for delaying an outright payment (such as tax considerations).
Other than ensuring a deal is inked, and assuming a continued interest, a seller would likely benefit from the prolonged involvement in the business. Most small business owners get into business because they are passionate about the business, and may find themselves in the common dichotomy of “I want to sell” but at the same time, thinking, “I want to keep running the company.” An earn-out connects these two, and gives the seller both.
There are items that might not be outright disadvantages, but things to stay on top of. The good news is that as long as the terms negotiated with the buyer are extremely clear and equitable for both parties, the seller can continue business as usual as long as they focus on those performance milestones, with the added benefit of a large cash deposit in their account after finalizing the purchase agreement.
Again, in order to avoid unnecessary drama and the potential of a forfeited payment, sellers should leave no grey areas in the paperwork when it comes to financial transparency. The buyer and seller should have an open-door policy when it comes to bookkeeping. This is mostly to ensure that the buyer (who is the new owner of the business) doesn’t inflate costs or misrepresent anything on the financial statements, especially anything that could impact an earn-out payment.
Both parties need to find the middle ground in a valuation procedure. A buyer will always bring a valuation lower than the seller, and it’s up to both parties (and perhaps an omnipotent third party) to come to an agreement. The adage, “A good deal leaves everyone slightly unsatisfied,” rings true here as well as anywhere else, and is extremely important when structuring a deal in order to avoid future conflicts or arbitration. Bringing a thorough business valuation to the table will give you leverage in the negotiation process in the form of credibility and professionalism.
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