What is your business worth? This is the difficult question that many entrepreneurs face as they look to sell their business. In fact, finding an amount that captures the strength of the brand and the future earning potential of the company, while balancing that upside with the risk that the new owner of the business would be taking on, is the biggest negotiating task that an attorney navigates when handling a merger or acquisition.
When there is a large gap between what a potential buyer sees as the value given the risk, and seller sees as the cost versus potential, one of the options often turned to is an earnout. If structured effectively, an earn-out can provide the business owner with compensation for the revenue upside that they have created, while alleviating some of the risk factors that could cause the purchaser to lose their investment.
Below is an explanation of what exactly an earn-out is, and a few tips on how to avoid an earn-out going south.
What is an earnout?
In mergers and acquisitions it is commonly understood that roughly three-quarters of all M&A’s end up falling well short of the initial expectations. Most business brokers or buyers will also have in the back of their minds the fact that around half of all deals result in a loss of value for the buyer’s shareholders. As a result, there is a natural proclivity to create as many safeguards as possible, while simultaneously building in the risk of failure into the purchase price. This often results in a price that is lower than what the current entrepreneurs are comfortable with given the company and brand that they have created. To bridge this financial divide, an earnout is often used to keep successful entrepreneurs invested and engaged in the business, while providing them the financial upside to fairly compensate them for the value they have created with the business.
An earnout is a contractual provision that states that the seller of a business is to receive additional compensation in the future if the business achieves certain milestones. Those goals are often tied to client retention, recurring revenue, revenue growth, or are stated as a percentage of gross sales or earnings. With that said, an earnout is often connected to whatever aspect of the business the buyer sees as the riskiest component, and can include whatever metric the two parties decide on.
Earnouts have the potential to be advantageous for both parties as long as they are structured in a way that makes the most sense for both parties. When negotiating an earnout, here are five tips for ensuring the highest likelihood of success:
1. Establish who is in control of daily operations
Since an earnout is a contingent payout which shifts some of the purchase price from the front end payment to the back end where it is tied to future earnings, sales, or other benchmarks of success (usually over a 3-to-5 year time period), how the business is run determines whether those goals can be achieved. A successful entrepreneur who is not given full control over how they go about achieving the earnout goals is at the mercy of those who have less experience and often less familiarity with the unique market they serve.
Rather than highlighting all of the times in which a purchaser decided they knew better than the successful entrepreneur who built the company, we will just say that it is often better to empower and enable the entrepreneur with resources and support around areas they do well, while supplementing their weaknesses and the things they do not enjoy focusing on.
2. Keep it simple
Earnouts that depend on a complicated matrix of variables and goals often have a higher chance of both not being met, and ending in litigation which can hurt the company and damage both parties’ investment as a result. Earnouts are most effective as an incentive for the seller when the size of the payout is determined by one or two simple variables that are mutually agreed upon.
Not only can complicated multi-factor earnouts be hard to motivate the team around, but they can often factor in variables that are highly affected by natural ebbs and flows within the market or the sector. Furthermore, some of the factors may end up being in conflict with one another. For example, earnout metrics that include earnings, customer retention, topline revenue, and costs can mean that the entrepreneur is incentivized not to heavily invest in changes that need to be made in order for the company to adjust to changing market conditions because it could reduce earnings in the short term – even if it would result in larger gains and better customer retention in the long run.
3. Keep the winning team together
No one person can run a successful company by themselves. Often, the success of a company, or of a department, can be attributed to a few key team members who have done a remarkable job. Throughout the process of acquisition, it should be an important focus of negotiations to ensure that those superstars that play important roles within the company are incentivized to stick around. Uncertainty around their role in the company moving forward, or their autonomy and how they will be treated, is often a factor in great team members leaving.
4. Limit the length of the contract
Especially when the entrepreneur has been successful building their company, there is always a temptation to draw up an incentive-laden contract that lasts forever. However, it is in the interest of both parties to find terms that maximize the potential for success and maintaining relationships and traction, while minimizing the potential for burn-out and disinterest given that it is no longer the entrepreneur’s solely-owned “baby.” The last thing anyone wants is an entrepreneur who has checked out or turned negative because they want to pursue other opportunities but feel chained to the business against their will.
5. Ensure that the incentives are motivating
Entrepreneurs require strong motivation to continue being successful. Without that motivation, the organization can suffer. This is why it is so important to create incentives that ensure the entrepreneur does not lose attachment to the company or its future goals post-acquisition. While it is natural to have at least a little dissociation after a sale, properly derived incentives that are developed with input from both parties, gives the company the best chance for success.
A company’s financial health, standing in the market, relationships with suppliers and partners, as well as cash on hand and recurring revenues are just a few of the considerations that should be taken into account when an attorney and business buyer or seller are negotiating. Often, these are the components that can affect the overall purchase price, as well as the upfront versus earned out compensation, and the split (90/10 or 50/50 for example), and overall time frame.
If you are considering buying or selling a business, reach out to our team at Hartmann Law Group to discuss your options and what you can do to best prepare for a possible acquisition.