Should I consider an earnout when selling my business?
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Should I consider an earnout when selling my business?
In the complex world of buying and selling a business, coming to an agreement on the proper price for a business can be difficult. An earnout is one element that may be a factor, but it is a complex element. Earnouts are difficult to administer and are prone to litigation. You should give careful consideration to an earnout before you agree to one.
An earnout is a useful tool in mergers & acquisitions and is commonly used by businesses in a variety of industries. An earnout is an arrangement where the buyer pays the seller additional money based on some metric, such as if the business performs well after the The event where possession of the business normally changes .... Earnouts are a useful way to bridge a price gap between the perceived value of a business between the buyer and the seller.
Price gaps are common in mergers & acquisitions. The seller, who may be emotionally invested in their business, often believes the business should be valued higher than what the buyer believes the business is currently worth. Earnouts are also commonly used when there is a disagreement about the expected future growth of the business and not just its present value.
An earnout essentially means the seller must earn part of the purchase price based on the future performance of the business, or some other metric. Part of the purchase price is paid at closing and the remainder is paid after the closing, with the final amount to be paid based on the future performance of the business, or some other metric.
The typical term of an earnout is one to three years at approximately 10% to 25% of the purchase price. Earnouts are popular with private equity groups that do not always have the expertise to run a business and want to keep the owner incentivized following the closing.
For example, if a seller thinks their business is worth $5 million and the buyer thinks it is worth $4 million, they could settle on an initial price of $4 million, and the $1 million difference would be structured as an earnout, which would only be paid to the seller if the business performs well.
Earnouts are most commonly used to bridge price gaps.
What is the value of a business? That depends on who you ask.
When there is a difference in perception of the value of a company between the buyer and the seller — or a difference in perception of the current value or of the future growth of the business — an earnout can be a pragmatic tool to bridge that price gap.
Earnouts are a useful way to bridge a price gap between the perceived value the seller and the buyer have for the business.
When do you use an earnout?
For buyers, structuring the sale as an earnout offers the following benefits:
For sellers, structuring the sale as an earnout offers the following benefits:
When deciding to structure a sale as an earnout, use caution. Earnouts are prone to litigation. There is a lot of risk in any transaction that involves future conditions, especially when the seller is expected to essentially work for a new boss.
The seller should realize that they are no longer in control of the business after the closing and during the earnout period. The seller, who was once the owner and sole decision-maker of their business the day before closing, must now understand that the conditions of the earnout must be met on the buyer’s terms because the business is now owned by the buyer.
First, determine how much of the purchase price you are willing to risk on the earnout portion of the transaction. Most earnouts are tied to the future performance of the business over a one- to three-year period.
The amount of the earnout primarily depends on the risk involved.
For example, if there is a customer concentration issue and most of the revenue is generated by one or two customers, the earnout may be a very high percentage of the purchase price.
A critical question to ask and consider is: What is the earnout based on? Is it based on revenue, earnings, or some other criteria? Here are five ways an earnout can be structured. All have pros and cons and the circumstances of the specific sale will determine what the earnout should be based on.
As previously noted, a buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduction of the earnout. Earnouts are easily manipulated and should be used only if there is complete trust between the parties. If one of the parties wants to, they can easily manipulate the calculation of the earnout.
Take Google, for example. Google used earnouts extensively when purchasing companies and would base the earnouts on milestone-based compensation and other criteria. Now, however, they have stopped using earnouts because they found it was too difficult for them to calculate the earnouts because the data they were based on was so easily manipulated.
A buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduced earnout.
Many sellers and buyers forget to take into account several other factors that can influence the earnout. Here are some factors, in the form of questions, that can affect an earnout and should be considered before one is entered into.
When structuring an earnout, avoid all-or-nothing cliffs. Earnouts should not be all or nothing. Rather, they should be based on a graduated scale.
For example, if the seller must achieve $10 million per year in revenue, but that year they only achieved $9.9 million, then they should not forfeit the entire earnout payment. Instead, they should still receive a portion of the earnout.
Whenever there is a cliff in the calculation of the earnout, there tends to be a lot of disagreements and manipulation of the calculation if the calculation is close to the edge.
Finally, hire the best advisers you can because earnouts are frequently subject to litigation. Have the right professionals in place to help the earnout be a success.
Earnouts work very well if your company has a track record of meeting budgets and projections. Earnouts are used commonly in the following scenarios:
Earnouts tend to work very well when the buyer is going to run the business the same after the closing as the seller ran the business before the closing.
Certain types of companies that often use earnouts include the following: consulting companies, companies where the owner is responsible for much of the sales, companies where there is no formal management team, companies whose family members are heavily involved in the company, and professional practices.
Earnouts are mostly treated as installment payments, which allows the taxes to be deferred. They are also used for tax strategies in mergers & acquisitions. We recommend that you consult with your CPA or tax advisor to consider the tax implication of the earnout before considering one.
An earnout is an indispensable tool to close more transactions. However, selling a business in this way has its share of risks, and buyers and sellers should take precautions when using an earnout. Hire the absolute best advisers you can and carefully draft the purchase agreement to accurately and completely address the earnout. Earnouts are very subject to litigation, so hire an experienced attorney. When used properly, earnouts are a powerful tool to bridge price gaps and sell businesses in a way that benefits all parties involved.
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