When negotiating the purchase price of a business, a buyer would be well advised to avoid getting into the specific deal terms too early in the negotiations.
The reason being is that a buyer needs to get the seller fully committed to the deal and mentally spending their proceeds in order to negotiate the best possible deal terms.
But what are the terms separate from the actual sale price you may ask? There are countless aspects to the deal separate from the legal ones with the most important ones being the financing, seller training periods and compensation and earnout structures.
In this post, I want to discuss earnouts. The mere fact that business brokers hate them, is ample proof how effective and advantageous they can be to the buyer.
Earnouts, by definition, are a component whereby the parts of the purchase price are only earned if certain events materialize after the new owner takes over. For example, there can be an earnout whereby the sellers gets paid an additional amount as long as future sales hit certain levels, or remain at certain levels.
So when should an earnout be used? Generally, in any business where there has either been a significant decline or increase in recent years, or, the potential for either of those scenarios to materials would lend themselves to an earnout. For example, a company generates a disproportionate amount of its revenue with a very limited number of clients. A buyer needs to be sure those relationships will continue. After all, if they don’t, not only will the business be worth far less than it was before, it may be worthless.
As an example, a company is being sold for $600,000 based upon a three times multiple of its Owner Benefits. During the buyer review, it is determined that fifty percent of the $200,000 comes from one key customer. If that customer stops buying, the business will actually only have $100,000 in Owner Benefits and thus will be worth far less than $600,000. Assuming the parties agree on the three times multiple, you set a purchase price at $600,000 BUT, only $300,000 is guaranteed. The balance is part of an earnout whereby after a certain period (i.e. 12 or 24 months) a determination is made related to the one big client’s volume. Assuming they have continued at the prior pace the seller gets their balance. However, if sales with them have declined or disappeared they only receive a commensurate amount.
Let’s say the Owner Benefits attributed to them declined to $75,000 from the origin $100,000. The three times multiple would then be $225,000 and so the seller will earn the additional $225,000 and not the full $300,000.
In cases where a company has had significant increases as the result of a recent event, or, perhaps, from a seller’s perspective, recent work or investments they have made in the business will only yield results after the new owner takes over. In these cases again, an earnout can address these potential events.
A key to earnouts is to make them simple, meaning, the measurement should be straightforward such as sales, number of clients, etc. It is equally important to articulate the precise formula that will be used to determine the earnout and again, keep it simple.
The single most important aspect to earnouts is that they offer an added layer of protection to the buyer for the future of the business and they can as well, in certain cases, be extremely beneficial to the seller as well.