An earnout provision is a contractual arrangement in which the seller receives additional payment in the future if certain financial goals are met, and if you are selling a business, the buyer may want to pay part of the price this way. Basically, part of the price is contingent on the performance of the company after the sale.
Increasingly Common Deal Term
Earnout sales are becoming more common, especially in high-growth companies, those with unproven products, and situations when the buyer and seller disagree on valuation issues. By some estimates, up to half of small business sales involve earnout provisions lasting two to five years, typically involving 15 to 50 percent of the purchase price.
You may be wondering what earnout provisions are based on. The target goals generally involve net income, gross revenue, the number of new customers or earnings before interest, taxes, depreciation and amortization (EBITDA), but It varies depending on the agreement.
An earnout may sound attractive, but here are five dangers to watch out for:
Danger #1: Losing Control
Obviously, you’re no longer in control after you sell the business. This factor can affect the bottom line and ultimately, your payout. For example, let’s say your payout is based on the net income of the company for the next few years. You’re now subject to someone else’s management and accounting practices, and there are many ways the new owner could intentionally or unintentionally suppress net income by inflating overhead or accelerating capital expenditures.
Net income could also be affected negatively if the new owner decides to make substantial changes to the company’s processes and operations. Perhaps the new owner doesn’t have much expertise in the industry, or the customers may prefer dealing with the current management. That could result in the business suffering through a few rough years of low revenue, which are the very years that determine your earnout payments.
So, what can you do? The most obvious answer is to get the biggest upfront payout possible. Try to limit the earnout to the amount you are willing to lose. Then, if the business begins sliding after the sale, at least you have some level of protection.
Or you might negotiate to have your earnout payments based on a target other than net income. It may be beneficial to use gross profit or some measurement that is less easy to manipulate.
In order to help ensure that the target goals are achievable, ideally you should build some measures into the contract. For instance, say your earnout is based on the number of new customers, but the new owner slashes the marketing budget. Without any control over marketing, the chances of meeting the new customer target are slim.
Danger #2: Ambiguous New Role
When a business is sold, part of the package often involves the seller staying with the company in a new role as an employee or consultant. This allows the seller to ease into another project or retirement while providing guidance to the new owner. If you agree to a new position, you’ll obviously be in a better position to keep an eye on the bottom line, although ultimately, you’re still not in control. You want to make sure that employment or consulting contracts do not include clauses that allow the new owner to demote or replace you after the sale closes. There may be personality clashes or the new owner may be ambivalent about having you stay on in the first place.
You’ll also want to make sure that a non-compete clause doesn’t keep you from pursuing other projects you are interested in, and you want the contract to include a way to exit gracefully. It’s smart to negotiate an exit strategy that allows you to leave early without forfeiting the payments if you agree to remain during say, a three-year earnout period, but find yourself miserable in the role.
Danger #3: Not Getting Details Right
It’s important to have a professional advisor iron out the details of the agreement because disagreements can arise if the parties interpret the terms differently. In some cases, buyers and sellers wind up in court. You need someone who thoroughly understands your business to facilitate the best results.
The basis for your compensation needs to be spelled out in clear terms. How will the payments be structured? When will they be made? The buyer may want payments to be based on net income, arguing that it is the best indicator of the business’s performance, but it may be better to base payments on gross revenue or another measure. As the seller, you can insist that the earnout formula include certain caps on items, such as on the amortization of goodwill, or the depreciation claimed on capital investments after the sale.
Another issue to consider is the possibility that the buyer will turn around and sell the business before all the payments are made. You may want to include a clause in the contract that accelerates your payments if the business is resold. Or, negotiate a guarantee that you will have a stake in the proceeds if a sale occurs before your earnout is complete.
Danger #4: Overlooking Tax Issues
The buyer and seller should plan carefully for the tax consequences whenever a business is sold. There are important considerations depending on factors such as:
- What type of business structure is in place at the time of the sale (C corporation, sole proprietorship, S corporation, partnership, LLC, etc.),
- Whether you sell stock or assets, and
- Whether the earnout will qualify for the IRS rules on installment sales, and
You want to structure the sale to minimize the tax liability on the proceeds. Consult with your tax adviser about the best way to structure the deal.
Danger #5: Not Having Audit Rights
Consider retaining the right to have an independent audit of the financial statements that determine your earnout payments. Since there will probably be changes in the company’s accounting or management practices, an independent review can frame the post-closing financial statements in terms that are comparable to the way business was conducted before the sale. In other words, you want to compare apples to apples.
Keep in mind there may be some unpredictable situations, that no matter how many details and scenarios you plan for. Decide in advance how disputes will be settled. For example, some buyers and sellers decide to stipulate in writing that the agreement will be subject to binding arbitration.
The Biggest Danger: DIY Earnouts
A valuation professional who’s experienced in mergers and acquisitions can help protect future earnings, point out pitfalls that might be overlooked and keep a lid on emotions that may boil over when discussions get heated. An earnout might be a good way to bridge the valuation gap when selling a business, but they are not a do-it-yourself project.