Contrary to what many sellers believe, an earn out component to a business sale is not necessarily a bad thing. As an M&A firm, we see the incidents of bad buyer behavior, but if properly used an earn out can be an excellent tool to maximize seller proceeds. First rule of earn outs – if you do not trust the buyer, there is not enough contractual language available to protect you. I will go one further. If you do not trust the buyer, do not do any kind of deal with him.
If you are negotiating the sale of your business, you want an earn out to be structured so that if the guy you negotiated with and was the deal champion gets “hit by a truck’ his replacement cannot interpret the agreement to your detriment. If you can, you want to have your earn out based on top line sales as opposed to division profits, for example. It is amazing how an overhead allocation from corporate can wipe out your division’s earnings.
So once you have your earn out based on top line revenue are you safe? What if your company’s product were added to the acquirer’s suite or products? What if your product were used as a loss leader to help sell the other products? Just like that, your earn out revenue disappears. The way to protect yourself is to establish a minimum sales price for your product for purposes of your earn out calculation. You don’t want to try to dictate pricing to the new owner. You simply want to be given fair credit for the revenues that would have resulted had your product sold at historical levels.
In spite of the risks, however, there are many reasons a seller would want to employ an earn out to maximize his business valuation. Here are a few:
- The seller has several big deals in the sales pipeline and wants to get paid for them. The buyer is going to heavily discount those forecasted deals if he is backed into an all cash at close structure. If the seller is willing to share the risk for those deals closing with an earn out component tied to the deals, the buyer will be much more generous. If the deals don’t close, it costs the buyer nothing. If they do close, he is happy to write you the earn out check.
- The seller anticipates that product sales will explode once the buying company integrates it with their distribution network. If the seller does not have strong sales or profits, but has a great product, it will be difficult to get the optimal selling price using historical sales and profit figures. Rather than take a low price based on those numbers, it may be better to bet on future performance and base a major component of transaction value on sales generated by the much larger company. Receiving 20% of a 10 times greater sales number as an earn out is a big win for the seller.
- An earn out can help bridge the value gap between buyer and seller and be the needed catalyst to getting the deal completed.
The use of an earn out can be appropriate as a way for a seller to maximize his sales proceeds in the right circumstances. Just remember that the buyer champion that has established a relationship with you and is compelled to honor the intent of the earn out agreement will most likely be transferred or promoted before your earn out term is completed. You now are in the position of having this agreement interpreted by a person who has no connection or loyalty or knowledge of the intent or the agreement. His mode will be to interpret the agreement in a way to “minimize the expense of the future payment.” Just make sure that interpretation cannot destroy the economics of the deal you originally negotiated.
Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry. His varied background includes positions in hardware sales, IT Services (IBM’s Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com