What to Consider Before You Commit to an Earnout
As you prepare to sell your business, try to anticipate issues that might slow down the process. For example, how will you respond if the buyer stipulates that an “earnout” must be one of the conditions for closing the sale?
What is an Earnout?
An earnout is an agreement in which the buyer will pay you a specified amount for helping the acquired company meet specified goals after the sale closes. The goals may be related to revenues, gross margins, net profits, or other financial metrics. Or, an earnout can be related to non-financial goals such as retaining employees. keeping high-value customers, or completing a technical project.
Buyers offer earnouts if they believe you have overestimated the value of your company and prospects for growth. Sometimes buyers offer earnouts to help maintain relationships with key customers and ensure a sense of continuity during the post-sale integration.
An earnout gives you a financial incentive to prove that your financial projections can be achieved. The buyer reduces the risk of uncertainties about the value of your company and enables them meet their own objective of closing the sale quickly. It also reduces the amount of taxes that must be paid when the deal closes.
Earnouts are common in middle-market M&A transactions that involve privately held companies and sometimes can represent as much as 25% of the total purchase price.
Drawbacks
Although an earnout can be a practical way to get a deal over the finish line, the business seller should be aware of potential pitfalls.
Loss of control, stature, and identity. Selling a business is an emotionally exhausting experience. Although you may feel a sense of relief and freedom when the deal closes, you may also suffer a profound sense of loss if you aren’t mentally prepared for what comes next.
This is particularly true when an earnout requires you to stay active in company operations for years after the sale.
Many entrepreneurs are unsettled by the sudden shift from visionary leader/decision-maker to supportive, task-oriented employee. As the new owners make changes to the company’s culture and operations, the seller feels helpless.
Rough post-sale integration. During any post-sale integration process, your employees will be expected to adapt to the norms and expectations of the acquiring company. If you remain active in the company, some employees might have a false sense of hope that the culture and practices of the current workplace will continue. Employee resistance to change can impede the post-sale integration process and disrupt synergies the buyer planned to achieve by purchasing your company.
Unrealistic earnout targets. The optimistic projections you gave for imminent growth were based on conditions that existed before the sale. If key employees or key customers left after the sale was announced, you might find it harder to meet the earnout targets. Or, the new management of your company might have different accounting practices and metrics for achieving your targets.
Post-sale disputes. In an ideal world, keeping the company seller involved after the sale closes would smooth the company’s transition from one owner to another. But costly, time-consuming disputes often arise due to different interpretations of the earnout agreement.
Misplaced focus. During the earnout period, the seller might focus exclusively on achieving the objectives required to cash in on the deal. This short-term thinking can hamper the company’s ability to build a strong foundation for longer-term growth.
Burnout. If you want to leave the business because you feel totally burned out, you might not have the drive required to meet the earnout targets. If you forfeit the earnout by walking away from the company, you may have sold the business for less than its true value.
What to Do
Think about your willingness to stay with the company after the sale. Are you interested in seeing key projects through to completion? Or are you eager to make a clean break and move on to the next chapter of your life?
Understand the buyer’s motive. Is the earnout structured to incentivize you to stick with the company? Or is it primarily constructed to mitigate risks to the buyer?
The rationale behind the earnout matters in determining whether it’s a win-win proposition that benefits both the buyer and the seller. For example, if you are satisfied with the amount of money the buyer has agreed to pay at closing, the earnout amount will feel more like a bonus than a necessity.
Make sure the earnout is clearly defined, measurable, and incapable of being manipulated. The buyer will be tempted to take steps to minimize the earnout, while the buyer is highly motivated to maximize the earnout.
Get advice from accountants and lawyers who are experienced in mergers and acquisitions. Unlike the lawyers and accountants who handle routine business matters, true M&A experts will understand how easy it can be to manipulate earnout clauses, particularly if the accounting practices are unclear. Before accepting the earnout terms, be realistic in analyzing the probability of achieving the targets.Qualified M&A advisors can also help ensure the earnout isn’t structured so that you assume the standard economic risks inherent in everyday business operations.
Do reverse due diligence. Speak to former owners of companies that the buyer has acquired. Determine whether the buyer can be trusted to follow through with the terms of the earnout agreement.
Insist on operating as a stand-alone company while the earnout agreement is in place. This will make it easier to accurately determine if the financial goals of the earnout provisions are achieved. However, buyers may balk at this request because it will delay the prospect of integrating the acquired company to achieve the full benefits of synergies between the acquiring and purchased companies.
Be professional at all times. Some buyers offer earnouts because they don’t entirely trust the seller. Sellers who can’t remain level-headed and rational throughout the negotiations process will reinforce the buyer’s perception that they can’t be trusted. Having an intermediary during the negotiations phase enables you to privately vent your frustrations.
Earnout agreements can be complicated. In addition to determining specific targets, both the buyer and seller must agree on terms related to control of business activities, payments, and termination of the agreement.
The LaManna Consulting Group has helped dozens of business owners prepare for earnout agreements and other issues that come up during the sale of their businesses. Call me at 561-543-2323 and I can recommend resources and experts who can help you avoid that all-too-common complaint: “I wish I knew about that before I sold my business.”