While earnouts can be an excellent tool to bridge the value gap and maximize an owner’s take home value, the concept does not ring well with most owners…unless they and their advisor know how to use the tool.
In order to know when and how to use the tool we should first look at how and when NOT to employ this strategy.
Don’t use an earnout:
- As part of the core value of a company that is based on current and past earnings.
- To help a weak buyer “finance” your company.
- In general, if you will not keep running the company during the earnout period.
There is also one situation where an earnout is a great piece of the pie. That is when the buyer is paying a high value for the company before you tack on the earnout. It is then Gravy on an already good deal.
Answering the question of when to use an earnout is not so black and white. Earnouts come in all shapes and sizes and can be tightly managed or simply something thrown against the wall. Remember when negotiating an earnout, or whether to use one at all, the major question is “Is there a deal out there that pays me as much without the use of an earnout?” Earnouts should be a valid way to maximize what you are being paid for the future by allowing the buyer to share some of that risk with you. This goes back to the tenet of valuation, “Lower the buyer’s risk, and you raise your reward”.
Some earnouts are designed to protect the buyer from your company going downhill after the sale, often due to a fear that customers may bail if the owner leaves. This type of earnout can be managed by the seller agreeing to stay while his customers get used to the new owner and realize that little will change. The validity of this structure is based on how tightly the customers (or a major customer) are tied to the owner. These should be short term (less than a year), and be tied to the revenue generated by your current customers.
A riskier earnout is very common and is one tied to the growth of the company after the sale. There are as many ways to structure these as there are buyers. If the amount is in proportion to the rest of the structure, then negotiating the appropriate terms and conditions are crucial to maximizing the value and minimizing the risk of not getting paid the full earnout. Some ways to sharpen the “tool” include:
- Don’t let the earnout targets be out of the range of probability.
- Full negotiate and document how the calculation of the earnout and the calculation of the particular financial yardstick will work.
- In order of preferences to the seller, the three most common yardsticks are:
- Gross Profit
- Never use an “All or nothing” approach, whereby if you hit the target you are paid and if not you get nothing. Always use some form of scale between nothing and everything.
- At the end of negotiations, always then ask for an upside, so that if you beat the agreed upon targets, you can get additional upside. What does the buyer have to lose?
- In negotiating a profit based earnout, the seller must manage the impact of the buyer’s decisions that will affect the ability to hit the targets.
- Negotiate and document what expenses will count against the profits. An obvious example would be “management fees” paid to the new parent.
- A good approach is to be able to “exempt” any new expenses that will negatively impact your ability to hit a target. The new owner may want to, for example, add more sales people, or new products that will be good for the company’s future, but would negatively impact the year in which those costs are initially incurred. You aren’t telling him he can’t do them, just that they will not count against your earnout.
- However, don’t cut off your nose and disallow expenses that would, indeed, help you as well as the new company.
- Keep the earnout period as short as possible.
- We sometimes help close a gap with an earnout that is only dependent on the current year end hitting a certain number. That earnout is to be paid as soon as the year is closed.
- A long earnout period is three years, including the upcoming year end.
- Make sure you get paid for each year as it closes.
- Also make the targets “cumulative”. This enables you to catch up in year two if you miss year one, or let year one’s excess roll over into year two, etc.
- Never say never, but you should not let the amounts earned in earnouts be placed into a note. This really extends the time it takes for you to get paid.
- If the buyer is a PEG, and is using senior and/or subordinated debt, expect the buyer (and the lender) to attempt to force you not to get paid your earnout until they have been completely paid off. They will push hard on this, and will usually wait until just before closing to spring this on you, blaming the lender. Trust me, they expected it all along.
- You can usually negotiate certain terms and conditions under which you can be paid.
- Once you have negotiated your best terms and conditions, push to be paid subordinated debt interest rates from the date you earn the earnout until you receive the cash.
- Close your deal and use the buyer’s money to grow faster than you would have done on your own dime.
Posted by Terry Fick.