Here is an excellent article by Dan Kolber, an Atlanta investment attorney and contributor to the Atlanta Business Chronicle. Dan offers some sound tips that sellers and buyers of businesses need to fully understand. Military veterans and transitioning military buying a business must understand all of the creative ways that sales prices are negotiated. Funding and funding sources remain a potential barrier to buying a business for your life after the military. In this article Dan arms you with powerful information you need.
Dan writes---A client was selling his small insurance agency to a large company. The buyer showed us fancy spread sheets projecting future income to justify his offer price. The buyer was attracted to my client’s agency because they specialized in a special type of retirement product.
Towards the end of the negotiations, my client said to the buyer, “You think my business is worth $8 million because you think you will sell $50 million worth of my special retirement product per year. I’ll sell you my business for $8 million cash at closing on one condition. If by some chance you end up selling $150 million of my special retirement product through my agency each year instead of your goal of $50 million per year, will you pay me 50 percent of the profit once you meet your goal?”
The buyer, thinking there was no way they were going to triple their projections, said “Sure!” and the deal was done. Six months later after the sale closed, Congress changed the tax laws and my client’s special retirement product became the hottest product around. My client’s last minute earnout netted him an additional $55 million!
This taught me the power of earnouts in selling a business.
An earnout means that the seller of a business will be entitled to receive additional compensation based on the business meeting certain financial goals in the years following the sale of the business.
Usually earnouts are paid out for a five year period after the sale of business. The amount of the earnout depends on the business meeting certain financial targets such as gross sales.
If you are a seller, you would want the earnout based on the simplest metric such as gross sales while the buyer usually wants the earnout based on net profits. Basing the earnout on net profits increases the risk of litigation because there is a greater likelihood of disagreement as to what expenses are to be deducted in arriving at net profits.
Sometimes earnouts are based on something other than income, such as the accomplishment of some milestone, such as getting FDA approval for a new drug or the granting of a patent.
The biggest problem with earnouts is that it violates the No. 1 rule of deal making which is: Cash is king. Tax considerations aside, generally it is always better to get money upfront for your business at closing when you give the buyer the keys to the plant. Future payments of any kind are inherently risky.
1. Timing is critical in negotiating the sale or purchase of a business. At the beginning of the negotiations, generally the seller should indicate he may be open to some type of earnout but his primary concern is cash. On the other hand, successful buyers often tell the seller upfront they are interested in buying the business primarily on an earnout basis.
2. Earnouts should always have some provision for accelerating the earnout payment upon some contingency such as sale of the business by the new buyer, bankruptcy of the buyer or departure of certain employees.
3. A key part of an earnout is who will operate the business after it is sold. If the buyer is not involved in running the business after the sale, he needs to be aware of the risk the seller may be able to run the business in a way that will prevent the business from meeting its targets such as paying high salaries to employees. This would result in a lower earnout. If the buyer continues to run the business after the sale, the seller needs to ensure the buyer is not operating in such a way as to optimize short-term income which would result in a higher earnout.
4. Earnouts result in a lot of litigation because when things don’t work out as planned. Both parties should have a litigation reserve.
5. Do your due diligence. Some industries are notorious for not honoring earnouts, such as the entertainment industry which uses a special type of accounting that tends to depress income. Beware of “bust out operators” who get possession of a business through small up front payments and renege on future payments while milking the business of its assets.