It won’t surprise anyone to know that the seller of a business almost always thinks that the business is worth more than the buyer is offering, just as it won’t surprise anyone to know that the buyer almost always thinks the seller is asking too much. One way to close the deal gap to the satisfaction of both parties can be through earnouts in the sale of a business.
Internet-based Investopedia says an earnout is “…a contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future goals.” It goes on to say that “…the future earnings are usually stated as a percentage of gross sales or earnings.”
Let’s take a look at our view of how an earnout might work in the real world.
The owner of San Diego Widgets wants to sell. During last year’s recession, sales slipped to $8M from the previous year’s $10M, but the owner is convinced that the business is rebounding. The buyer is skeptical. For a number of reasons – not the least of which are the looming tax burdens on business sales due to take effect on January 1, 2011 – the seller thinks making a deal this year is in his best interest. He wants $2M, but the buyer is only willing to pay $1.7M. How can an earnout close the $300k gap?
The simplest way would be an earnout based upon a percentage of gross sales. The buyer might agree to pay the seller 5% of gross sales over $8M each year for the three years following the closing. If the company rebounds to $10M and remains at the $10M mark for the three years, the seller would receive 5% of $2M each year for three years. This is an amount equal to the $300k deal difference.
Why does this work for both parties? For the buyer, it protects the “downside.” If the buyer is right, and the business does not rebound, the buyer is protected and has not “over-paid” for the business.
The seller, on the other hand, gets full value if he’s right and the business does rebound. And to provide the seller with an incentive to take less now in exchange for the possibility of more later, the buyer has agreed to pay the seller an additional 2.5% on sales up to $12M. That means that the seller could earn an additional $150k if the business jumps to $12M and stays there. The buyer figures that the extra incentive will keep the seller interested in the success of the business and encourage him to help it grow.
So, an earnout can be a bridge to a deal. But there are two important things to consider in structuring earnouts that will make the bridge dependable and easily crossed.
First and foremost, the parties should insist that the earnout be based upon an objective and readily ascertainable criterion or benchmark, such as gross revenues. If the parties choose to use some other criterion, then the method whereby the less-objective criterion will be determined, and by whom it will be determined, should be specified. For example, if “net income” is the criterion, it will be affected by discretionary decisions regarding capitalization, deferral of revenue, allocation of overhead expense, and salary levels applicable to senior managers. Buyers and Sellers of small businesses should be cautioned that language such as “… in accordance with Generally Accepted Accounting Principles (GAAP)…” by itself is not sufficient and small businesses almost never have statements prepared according to GAAP.
Second, the sale agreement should specify what types of financial reports will be created, where will the records be maintained, who will maintain them, when will they be distributed to the seller, and on what schedule they will be made available. The Seller shall have full and complete access to all financial records, including source documents and accountant’s work papers, and the agreement should also prescribe that the Seller may inquire directly of Buyer’s in-house and outside accountants and may obtain documents directly from them upon request.
There are, of course, other considerations, and an earnout is best structured with careful consideration and with the input of an attorney experienced in business transactions.