In Part 6, we discussed handling communications of the sale with employees, customers, and other stakeholders. In this part, we will discuss earn-outs, a common component of the sale of many small and medium-sized businesses.
Step 7. Earn Outs
One of the key terms in the sale of a company is the price. Typically, the seller believes the company is worth more than the buyer is willing to pay. This could be because:
- The seller has just acquired a new customer, started a new product line, or opened a new location, and the seller believes this new initiative means the business is worth a lot more than historical results show.
- The seller may point to certain synergies that will result in lower costs, increased sales, greater margins, or other benefit to the buyer than the current financials show.
- In this COVID period, particularly during the first months of the pandemic, buyers were concerned that the seller’s business would be significantly damaged by supply chain interruptions, government shutdowns, and other pandemic-related issue. The seller might have more faith that the business is more “pandemic-proof.”
The Earn-Out Solution.
An earn-out is a classic way to bridge a valuation gap between buyer and seller. In an earn-out, the buyer essentially agrees to pay more for the business if certain operating results exceed an agreed baseline, over an agreed period of time. This may be the only way to bridge the valuation gap.
Factors to Consider.
In order to make an earn-out successful, the seller would want to consider the factors that are required for the new initiative, and add contractual provisions so the buyer will implement those things. Consider factors such as:
- Key personnel required for the initiative should be assigned to the initiative, and not be tasked with other duties.
- Key timing and scheduling items should be calendared and provided for.
- Other needed resources, including financing, materials, etc., should be provided for.
- The financial metrics must be established carefully, then tracked, and reported to the seller.
- The seller needs access and transparency into this process, perhaps under a separate non- disclosure agreement.
Case Study: Earn-out Gone Sideways.
A deal I worked on in 2007 gives a good example of an earnout that did not go according to plan. If you were doing deals in 2007, you remember that valuations were dropping swiftly. Closing a deal at that time was a victory, even with an earnout.
I represented the seller. The seller’s assets were acquired by a new subsidiary of the buyer, and the seller’s president was hired on to head up the new company. The president of my client had just started a new initiative that everyone (including the buyer) expected would be very profitable. We negotiated an earnout based on the results of that initiative. The earn-out was heavily negotiated. The buyer would only agree to an 18 month earn-out period. The earn-out provided the buyer would provide financial reports on the results of the initiative every 6 months.
As we reviewed the revenue reports, we realized several things were going wrong.
- The buyer had only begun the new initiative in name, but not in substance.
- The buyer had assigned the president to work on other matters, which the buyer argued were more important to the business as a subsidiary of the buyer.
- The buyer’s accountants were taking deductions from revenues that were not contemplated by the purchase agreement, arguing that “this is how we always account for these things.”
- Some transactions in the new initiative involved trade-in-kind, rather than cash, and the buyer’s accountants failed to report the cash equivalent of the trade-in-kind transactions.
The buyer was a large company, and what left of the seller was a shell that was kept in place to manage and distribute the earn-out amounts. Litigation was not an option. Ultimately, we were able to get the buyer to agree to pay on the earnout. The amount was significantly less than it should have been on the revenue numbers achieve. The amount was significantly less than in if the president had been allowed to work on the earn-out initiative.
Perhaps not surprisingly, the revenues from the new initiative increased dramatically after the earn-out period had ended.
Assuming you can negotiate the best earn-out possible, you can proceed to closing. If the buyer has the financing, that is. In the next part we’ll discuss seller financing as a tool to help close a sale.