A recent article in the Globe and Mail highlighted a condition of sale that, at first glance, appears to be a win-win situation for both buyer and seller; the earn-out clause. Earn-outs are a risk mitigation tactic used to eliminate some of the uncertainty that comes with estimating the value of a business. There is almost always a discrepancy between the amount a buyer is comfortable paying and what a business owner is willing to accept in a business sale negotiation. Business owners, especially those who have been with their company for an extended period of time, have a solid understanding of the ability of their business to perform in accordance with forecasted expectations. Buyers, on the other hand, are largely unaware of the inner workings and core competencies of the business, and thus base their offer price primarily on the estimate derived from a business valuation. When the inevitable disagreement in value occurs, whose price is right?
Business valuations are heavily based on future earnings potential, and thus trusting this potential will be achieved can be a huge leap of faith for a conservative buyer, causing them to lean toward the lower end of the estimated value spectrum as a way to insulate against risk. Both parties are primarily interested in maximizing value through the transaction, and one way to bridge the gap in desired price is an earn-out condition. In the case of a business sale, and typical of most things in life, everyone wants to maximize their return, but no one wants to take on the risk. Buyers offer a price they are comfortable with paying should an increase in value not be realized, with the potential for a larger payout to the seller depending on the achievement of certain performance objectives in the future.
Earn-outs can also be a way for buyers to ensure value does not leave the company with the exit of the current business owner. Many owners heavily involved with the day-to-day operations of their business have become integral to its success, increasing the risk for a potential buyer in a sale transaction. Protecting and increasing value is difficult when a transfer of ownership results in the loss of substantial human capital. It is, in many cases, beneficial for prospective buyers to have the seller stay with the company, ensuring that by the time the earn-out term has been completed, the new owner is equipped with the knowledge necessary to get the most out of his newly acquired business. The earn-out is also a period wherein current business owners can “put their money where their mouth is” and demonstrate the earning potential of the company firsthand to the buyer. This sweetens the pot for buyers who now bear less of the risk in the business transition, but what does it mean for the seller?
As popular as earn-outs are with buyers, sellers take on substantial risk in accepting this condition. Upon relinquishing control of their company, sellers face the possibility of losing access to the resources needed to make the changes necessary to achieve earn-out performance objectives. Budget cuts, departmental reorganization and other operational changes may make it difficult for sellers to increase value to the level needed for additional earn-out payment. Earn-out periods can also last longer than the seller intended to stay with the company, causing a frustrating delay in the intended exit from their business in order to achieve the desired payout. By staying on with the company in the case of an earn-out, the previous business owner becomes, in effect, an employee of the company. Sellers should take care to determine whether this position, and the diminished control that comes along with it, fits with their plans for the future.
The article points out the best way to ensure a successful transaction for the seller: the sale price, inclusive of both cash on closing and any vendor financing, but exclusive of any negotiated earn-out, should be satisfactory to the vendor even if no additional funds are received as a result of the business’ performance post-closing. The author recommends that any payout on top of this amount should be perceived as a “bonus” for business owners. If you are happy with what you have received upon the initial sale, integrating the new owner into the business and helping to achieve performance objectives becomes less critical, lowering the amount of stress associated with the process and feelings of dissatisfaction if performance targets are not met. When the initial payout was already sweet enough, earn-out payments are just the icing on the cake.