In planning the sale of your firm be ready to accept that around 40% of the purchase price will not be paid on sale. Typically you could wait for between one and three years to collect all your proceeds – and even then you may be disappointed. So how to be prepared? This is how.
Firstly, seek to negotiate a deferred payment instead of a conditional earn-out. Deferred payments lock in a valuation at the point of sale and merely delay payment over an agreed period, usually conditional on the vendors remaining in the business for an agreed period. So at least you know what you will get and when you will get it. Whereas earn-outs will be based on one or more KPIs and formulae to calculate a payment, and possibly even the timing of the payment. Earn-outs may allow the vendor an opportunity to share in increased upside, but usually the carrot being offered is a means to avoid being paid less.
One key point here that is often overlooked by vendors is that they should build in the likelihood that they will have to remain in the business for up to three years, post sale. And if they are tied to an earn-out, they may have to work harder than before! So don’t leave it too late to start the sale process.
Earn-outs impact behaviour
It is imperative to structure any earn-out with reference to your specific circumstances, and not be forced to accept an acquirer’s standard approach, or be bullied by lawyers who are far removed from the commercial realities of your business and its market – ‘one model’ does not fit all for earn-outs.
An earn-out takes time to negotiate and draft, and believe me when I say that it will be a point of contention in the future. On the face of it, it may appear straightforward to agree the commercial principles of an earn-out, but turning it into an enforceable legal document can be problematic, particularly if there are multiple targets with differing methods of measurement. There has to be a trade-off between an acquirer’s excessive risk management and avoiding a situation where the vendor spends more energy on tracking and measuring the earn-out targets rather than driving the business forward.
Not all acquirers seek earn-outs, many understand the negative impact described above. That said, others still use the method as a means to keep vendors committed during the transition and merger process, both to maintain financial performance and preserve the pool of expertise post-sale. Unfortunately, some acquirers that have overpaid for an acquisition may seek to use an earn-out as a means of reducing the price. This is no way to start a relationship and from our experience will almost certainly lead to an implosion of relations, with neither side winning in the long term.
Earn-outs – facts of life
The earn-out financial target
The earn-out target should be balanced as a win-win. It should achievable for the vendor and drive the right behaviours for the acquirer. Set it too high and it becomes a disincentive, too low and it won’t be incentive enough. Some tips from our experience with clients post-sale:
- Base the earn-out on the existing business plan deliverable as a standalone entity, with minimal interference in the acquired business. The fact that the acquired business will have access to new clients and additional resources is a plus, but should not be included in any earn-out metric.
- If there is to be a cap on an earn-out ensure there is a floor too. Avoid linking the earn-out to specific singularities or events, aim to have a stepped or a sliding scale structure that avoids the trap of a single trigger that can be manipulated by either side. Allow a carry-over, if targets are not met in one period, but are later – the vendor should not be penalised.
Keep it simple
It is tempting to try to make an earn-out achieve many different outcomes, but this is fraught with difficulty and will almost certainly be a distraction. At its most simple an earn-out should drive behaviour that creates value and growth for the acquirer, and satisfies the vendor’s ultimate expectations
Complexity of earn-out structure makes it very difficult to negotiate and document legally, and to measure post-transaction. The result is excess negotiation during the process and subsequent arguments post-close.
Integrating the businesses
Almost certainly an earn-out will prevent the full integration of the two businesses. The vendor’s business will need to be ring-fenced from an operating standpoint for the vendors to be responsible and accountable in meeting their earn-out targets.
This can destroy value for the buyer and also completely undermine the original rationale for undertaking the acquisition in the first place.
If aspects of the vendor’s business do become integrated into the acquirer, for example market facing functions such as marketing or business development, then this dependency will need to be factored into the earn-out metrics, usually by narrowing them. But this is not easy to achieve and the greater the metrics become blurred and subjective the greater risk of dispute and distracted goal congruency.
How long is long enough?
A two or three year period is typical. Given the vagaries of market conditions, accelerating disruption from new technology, substitutes and new entrants – the shorter the period the better for a vendor. But a shorter period also favours the discerning acquirer who is seeking full integration and the symbiotic synergies.
Corporate reporting and overhead allocations
The first area to be integrated will be the reporting and accounting function, even if operations are ring-fenced to allow for clear earn-out responsibility and accountability. So the vendor will almost certainly lose control of the financial reporting of their performance post-close. So be aware of any ‘allocated costs’ that could impact achieving the earn-out targets. Predicting how an acquirer will behave post-transaction and getting points of detail identified and addressed is a key role for any advisor.
The sting in the tax tail
Like any performance based payment there is a risk that the tax authority will look to treat it as income rather than capital, with the resulting higher tax rate that comes with it. Get good tax advice early.
Financial viability of the acquirer
Whether it is an earn-out or a deferred payment, vendor due diligence on the acquirer is essential. Also, know which corporate entity within the acquirer’s group will be party to the sale and purchase agreement. If, as is likely, the acquirer will be a local holding company seek a guarantee from the ultimate parent company.
As far as earn-outs go, the simpler the better over a short period. That way both the acquirer and the vendor can get back to what they do best, growing a profitable business. The longer an earn-out runs out and the more complex it is – the greater the risk of misplaced distraction. Think of it in terms of the multiple used in the transaction and where do you want management to focus – one dollar clawed back from reduced earn-out is still one dollar. One dollar of incremental profit gained through symbiotic growth is worth a multiple of that dollar. This is why discerning acquirers have moved away from earn-outs to deferred payments.
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Other related blogs and thought leadership from Beaton Capital can be found here:
- Selling the firm – does size matter?
- How much is my firm worth?
- 20 questions to test your resolve: do you really want to sell your firm?
- Earn outs: not worth the paper they are written on?
- Succession: trade sales – gain, pain, both?
- Takeaways from a recent sell mandate – points to consider when it comes to selling your firm
This post was written by Warren Riddell, of Beaton Capital and Beaton Research + Consulting. Warren’s details can be found at LinkedIn.
Image courtesy of Carlos Porto / FreeDigitalPhotos.net