Earn-outs: A Powerful Negotiating tool

In current uneasy markets with lower revenues, lower profits, difficult financing and lower business values, business owners considering the sale of their businesses are facing new and significant challenges insofar as receiving a price for their businesses that they feel comfortable with.
One key approach to getting around this dilemma is for sellers to turn to earn-outs for creating an approach to selling a business under difficult market conditions. There are many circumstances in which earn-outs can be very rewarding to a seller. These include the following:

  • Where a seller and purchaser disagree over projected earnings or other factors of value for the business. For example:

  • The seller has a line of new products for which the valuation would be based solely upon projections and where the purchaser and seller may have legitimate differences as to volume, pricing and even market acceptance.

  • Historical financial information may not illustrate the opportunities available to the purchaser when determining a purchase price. An earn-out that bases a portion of the valuation on actual future performance can enable the purchaser to soften the risk related to speculative projections.
  • Another instance would be where the differences in perceived value and the valuation approach of different analysis of economic issues, such as a given state of the economy or trends of the company being sold. Earn-outs can serve as a good bridge between these different assumptions.
  • Service businesses with long lead times oftentimes can only realize true value if the current management remains with the business.  The earn-out serves as a means for inducing the seller to remain in management to maximize profit for the purchaser, which management may only realize by meeting performance goals tied to the earn-out.
  • When the seller is committed to a valuation that appears to be unrealistic to the purchaser, benchmarks set by the purchaser based on the seller's projections would trigger a payment under an earn-out program which may appease that seller and close the deal.

Legal Protection for Seller

There must be an alternative dispute resolution process or binding arbitration in place, in order that the parties may avoid costly lawsuits to seek an interpretation and enforcement of the earn-out.

Structuring protections for the seller must be balanced while not unduly interfering with the flexibility of operation of the business post-closing. If the purchaser is constrained to operate the business through restrictive covenants, the earn-out protections are likely to substantially limit the purchaser's ability to modify, expand or contract the business’ operations or capital structure.

Verification

The seller should insist that the purchaser maintain separate books and records for the business if it is being merged with another business, during the earn-out period. The purchaser must agree that these financial records will be made available for review upon reasonable notice.

There are several accounting issues that may arise. Generally accepted accounting principles (GAAP) embrace a wide range of acceptable accounting practices and are subject to change. Therefore, for financial milestones, the parties should stipulate with as much detail as possible the accounting principles that will be used to calculate whether the thresholds have been met. The ability to manipulate results of an earn-out through adjustment to GAAP is often legitimately of great concern to the seller. Particular care in delineating the calculation principle should be used if the threshold is EBIT or EBITDA. The parties should incorporate into the acquisition agreement a description of the accounting principles to be employed.

For many reasons, when using an earn-out, we like to see the calculation kept as simple as possible by tying the calculation close to the top line, thereby avoiding or reducing the potential for calculation disputes.

Case Study:

We recently were retained to sell a business that had just completed a significant facility expansion. The principals of the business had used all their equity, and borrowed heavily from their bank in order to finance the approximately $5 million dollar facility expansion 

They quickly found themselves in financial difficulty as a result of a lack of working capital to finance the future growth anticipated by the expansion and even though the market indicated it was ready to provide more orders, further capital spending of ½ million dollars is now required for packaging equipment to meet the new needs of customers as a result of the changes the economic times was imposing on those customers.

While still profitable, the capital repayments required under the financing agreement with the bank was causing cash flow problems and restricting the business’ ability to finance receivables and acquire more inventory. More simply put: “The company was overtrading its equity”

 The expansion of the facilities gave the business the capacity to increase revenues on one shift to between $30 to $35 million dollars depending on product mix and timeliness of orders and on two shifts, to between $50 and $55million dollars, but working capital was restricting growth.

The purchaser’s value of the business was based on future discounted cash flow, but did not consider the growth potential of the business with proper financing. In fact the value was about the same as book value, and it appeared the clients had little choice but to sell at that price.

Enter the earn-out. The buyers conceded that the sellers had positioned the business for rapid growth and agreed to share some of the future profits if they occurred, with the seller, provided that the sellers agreed to remain and operate the business for the purchaser. The earn-out worked as follows:

On all revenues over $15 million dollars, a royalty payment of 3.5% was to be made provided the gross margin remained at past levels.  The royalty program was to remain in effect for seven years after closing. The purchaser’s rationalization for this was that at $15 million in revenue at historical margins, they would earn a satisfactory return on their investment.

 It became apparent to the purchasers throughout the negotiations that they needed the sellers to realize the revenue potential and to be able to operate the facility profitably at higher volumes.  It is believed by the owners that the earn-out provides them with the potential to double their selling price over the next seven years. It quickly became obvious to all that an earn-out was a win-win for both parties.

Summary

The economic downturn in 2008 and 2009 has prompted more sellers to consider and accept earn-outs as part of pricing the sale of their companies. Sellers today may believe that their company’s flat or declining performance will turn around quickly as the economy improves, yet purchasers are concerned about paying for future projections in uncertain times. An earn-out can bridge the disputed valuation gap.

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