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
The Problem
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 believes the business is worth a lot more than historical results show. The seller could also show certain synergies that will result in other benefits to the buyer like higher profit margins that haven’t been fully realized yet. The question is: How do we align the “valuation gap” that occurs between what the seller believes the business is worth, and what the buyer is willing to pay for it?
The Earn-Out Solution
An earn-out is a standard way to bridge a valuation gap between buyer and seller where the buyer agrees to pay more for the business if the operations exceed a certain financial baseline over a predetermined period of time.
Factors to Consider
In order to make an earn-out successful, the seller must consider the new, value-increasing, initiative’s required factors, and add contractual provisions so the buyer will implement those initiatives. Factors to consider include:
- Key personnel required for the initiative should be assigned to the initiative, and not be tasked with other duties.
- Key timing items should be scheduled and planned for.
- Financing, materials, and other necessary resources should be provided for.
- The financial metrics used to determine the initiative’s success must be established carefully, tracked, and reported to the seller.
- The seller needs to maintain access and transparency during the earn-out period, which could be set up under a separate non-disclosure agreement.
Case Study: Earn-Out Gone Sideways
A deal from 2007 gives a good example of an earn-out that did not go according to plan. Given the nature of the economy in 2007 (the great recession), valuations were dropping swiftly. Closing a deal at that time was a victory, even with an earn-out.
In this deal, 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 earn-out 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.
Based on the financial reports, 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 was 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, the seller was able to get the buyer to pay on the earn-out, but it was significantly less than it should have been based on pre-deal numbers. The earn-out amount was also significantly less than expected 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 ended.
Earn-Out Conclusion
Earn-outs can be complicated and should be negotiated and drafted with the assistance of an experienced M&A attorney and an accountant. All the tools necessary to make an earn-out successful, and all the actions on the part of a buyer that can make an earn-out a bust, should be thought through and accounted for in the purchase agreement. With the help of your attorney and accountants, you should be able to maximize your earn-out and then proceed to closing.
