As the owner selling a business, you want to maximize the sale price you receive. But may value the company at a greater amount than a prospective buyer, especially in an uncertain market with a lot of risk for the buyer. The buyer may be uncertain of how the COVID situation will impact earnings after the purchase. It is uncertain times and no one can predict how long the shut-down will last or the long-term impact on the economy. Earn outs are also useful when it is difficult to value a business or for new businesses whose track record of profitability has not yet been fully established. So what can you do when you and a potential buyer are at odds over the fair market value of the business? One option is to utilize an “earn-out” agreement.
An earn-out agreement is a transaction where the purchase price comprises two components. The first is an up-front payment at closing. The second is contingent (and calculated) based on the performance of the business after closing. It includes one or more further payments based on the performance of the business over subsequent reference periods based on turnover or gross profits. It is intended to bridge the gap between an optimistic seller and a skeptical buyer by allowing the buyer to close at a lower up front price that represents the minimum value of the business based on the lower end of the anticipated revenues and additional sale proceeds if the business achieves or surpasses certain performance metrics. While the metrics need to make sense for the type of business and industry, the most common will be gross revenues. Gross revenues are typically used because they are objective and remove disagreement over how profits are calculated.
The Seller may be able to negotiate a more lucrative deal with an earn out, so that both buyer and seller can benefit from good performance post-closing. By sharing the risk on future performance, the potential upside may be greater than the buyer would be willing to pay on a fixed price deal.
Advantages
Earn-outs also give a seller a great chance to close a deal with a buyer who may be hesitant to rely on the future forecasts because of the unknown impact of the COVID crisis or where the buyer or its advisors valued the business using a different method. There are many accepted methods for valuing a business and many different models for generating predicted income streams, return on investment and market valuation. The impact may be milder than feared and have little long-term impact on the business revenues for the rest of 2020. Earn-outs allow business owners who sell their business to benefit from their hard work by increasing the sale proceeds in this situation. In that case, it is a win-win for both seller and buyer. An earn-out can defer some of the tax burden that arises from the sale of the business, since the seller will not have to pay taxes on the earn-out profits until they are actually earned.
For the buyer, earn outs have the advantage that if the performance of the business fails to reach the targets, then its obligation to make further payments to the seller will be reduced or even eliminated. Accordingly, an earn out allows the buyer to hedge its risk on an acquisition and prevent it from paying too much.
Disadvantages
The seller may not receive security for the deferred payments and will have relinquished much of its control, leaving a situation where buyer can devalue the business through mismanagement, over spending or underfunding. Earn-outs require careful drafting. They are complex documents that require careful consideration to establish clear calculations and timelines for the contingent post-closing payments. There also must be incentive for buyer to maximize sales and controls against underreporting. The seller will need a right to audit and verify the calculations.
The buyer and seller will need to negotiate issues such as how to handle new product or service lines introduced by buyer that generate significant revenue and whether such revenue should be included in the calculations. A negotiation will also be needed as to what conditions should be established post closing to ensure that performance targets can be achieved and revenues maximized. These can include things such as buyer being required to invest some minimum level of marketing or effort promoting the the business and products or services and restrictions against the buyer materially changing some aspects of the business that could result in reduced revenue levels. The buyer, as new owner of the business, will want the freedom to make operational decisions about its own business since it is the one taking legal and financial risk. It can be a delicate balance between the interests of buyer and seller.
How the deal is structured ultimately comes down to the relative bargaining position of the buyer and the seller.
There are other creative approaches to structuring a business sale transaction. For example, the seller can consult or be employed by the buyer after closing to provide an additional revenue stream after closing. Another option where seller financing is involved is to have a note with slightly higher than market interest and a penalty for pre-payment. The guaranteed interest income can supplement the purchase price.
If you are considering selling your business, and especially if you are considering including an earn-out agreement in the transaction, please contact Tracy Jong right away to set up a consultation and allow us to analyze the potential advantages and disadvantages of utilizing such an agreement in your unique situation. If this is a good option for you, we can assist in drafting an effective agreement that protects your interests in the purchase or sale of a business so both parties face a more certain outcome.