Executive Report

Earn-Outs Gone Bad

Earn-outs are a common component used in the purchase of a business. They allow the buyer to shift some of the risk of purchase by overpaying the seller. The buyer withholds a portion of the purchase price pending the realization of the seller’s projections. As a consequence to the 2008 recession, the popularity of earn-outs began increasing in the late 2000’s, and as of 2013, they made up 40% of deal proceeds. What happens when an earn-out goes bad? How can you navigate the process? 

What Are Earn-Outs?

Earn-outs are attempts between two parties to connect the differences in their assumptions of valuation for a transaction. This is typically a move that protects the buyer, since sellers tend to have a more positive outlook on the future of their company and worth of their business’s assets. The seller needs to provide the financial projections for the company, and if the buyer is skeptical, he or she may suggest an earn-out purchase. An earn-out means only needing to pay the seller in full if the projected performance targets are met. 

Earn-outs surged in popularity after 2007 when many sellers found their recently purchased companies were not worth as much as projected, by no fault of the company themselves. During a time when business futures were uncertain, earn-outs gave buyers enough confidence to go ahead with a purchase. Earn-outs often contain clauses to incentivize the seller, too. If a business is estimated at ten million, the buyer can offer eight million in cash and an additional two or even four million in earn-outs funds. That means if all the target projections are met and exceeded, the seller stands to make an extra two million on the business. If the projections are not met, the buyer will only pay eight million for the company.  

What Makes a Great Earn-Out

The earn-out must be very specific in its terms. There are a wide variety of variables in play, and not all of them are obvious. The role of the seller is to minimize the number of assumptions being made by the buyer. Buyers should lay out each future possibility. What if the seller loses major clients? What if key employees leave? What if the market changes? What if the sales go through the roof–does the seller have potential to earn beyond the earn-out? Make sure that the seller can’t just give himself a bonus or other advance, and check for conflicting commissions. Non-compete and non-solicitation contracts need to be in place for key employees to mitigate financial losses. 

As a seller, it pays to be as accurate as possible with the company’s current state and future financial projections. Buyers should be wary of company owners “overselling” their business or only giving maximum profit numbers. Businesses often require deviating from the business model in times of raw material shortages, market changes, or new investments. While many trial and error scenarios can be troublesome for current CEOs, for someone new to the business, they could spell disaster. Buyers estimating future earnings should take into account setbacks and business plan deviations, especially if they plan to make changes to the company. 

Savvy sellers should be intimately aware of market projections and the rolling 12 for their company (revenue/profit earned over the last twelve months). Potential buyers will demand to know your profit/loss statements, current cash flow, and growth potential. Buyers typically underestimate the value of the seller’s business, so the more information you have, the less relative negotiation will be required. 

Another aspect you must consider is emotional readiness. How prepared are you and your key employees for the business sale? Will there be pushback? Are they expecting it? Are there any key employees that might leverage their positions for a stake in the sale? 

The Transfer Cycle

Regardless of when you’re considering the sale of your business, there are three questions that must be answered before making the decision: 

  • Are you and your company emotionally and financially ready? Key employees should be prepared for the sale, and you should be emotionally ready to let go of your company. 
  • Are company assets and other details prepared? Clients should be notified of the upcoming change (timing is critical), and your team must determine that the sale doesn’t involve a breach of contract, etc. Prepare your financial statements and analysis. 
  • Is the market ready? It pays to do market research within your industry. What type of growth opportunities exist for potential sellers? What challenges are faced in the current landscape and with changing technology? What are the market conditions, interest rates, availability of capital, and supply and demand of for your type of business?  

Robert Slee, in his book Private Capital Markets, describes his identification of ten year transfer cycles. He demonstrates that since 1980, there have been multiple 10 year transfer cycles. The first three years are Deal Recession (Buyer’s Market), approximately five to six years are Prime Selling Time (Seller’s Market), and two to three years are Almost Recession (Neutral Market). Therefore, market assessment and timing are critical factors in the sale of a business. 

Sellers should estimate that gathering all the necessary data, making the proper preparations, contacting a motivated buyer, and beginning negotiations takes could take up to four years, when done properly. Going through the process of selling and seeing the earn-out contract through takes another two years, on average. Earn-out contracts typically take between one and three years. Finally, a buyer should estimate an additional four years to complete the sale and for business operations to smooth out, according to Slee.  

In short, earn-outs are essentially figurative dividends or bonuses added to a transaction. It’s a means to an end for both parties. In the cases in which the seller remains with the company and has a hand in helping hit financial goals, the earn-out can even be viewed as a performance bonus. If the seller has no part (or a passive role) in the company’s future performance and the company fails to realize the financial potentials laid out by initial projections, the earn-out functions act as a dividend instead. The sale of your business is a journey, not and event. There is no better time than now to plan that journey. 

The very best advice for those contemplating a sale of their business is to seek out an advisor trained and certified in business transitions/exits. That person can speak about your specific situation and help predict obstacles. If you are ready to see where you and your company stand in regards to selling, check out the BERI assessment at LenMiller.com. 

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