Perspective is everything. Business sellers often think it’s difficult to find a buyer willing to pay what they think their business is worth. Buyers frequently feel it’s tough to find a company worth buying at a reasonable price.
Not surprisingly, the purchase price is by far the biggest sticking point when negotiating the sale or purchase of a business. Financial advisors, appraisers and trusted business associates on each side will differ as to what constitutes a fair price. One of the most common sources of disagreement in calculating the worth of a company involves the future sales and earnings projections. A seller feels he or she knows the business and the market and can correctly anticipate growth at a certain rate. A purchaser has done due diligence and believes he or she also understands the business and the market.
What can the parties do to get over this deal bump? A common method to resolve the impasse is to employ an earnout agreement — a contract where the seller gets paid a portion of the asking price up front and commits to having the business meet certain financial goals over a period of time to earn the money with which to pay him. If a seller’s projections are fulfilled, he will ultimately receive the compensation he was seeking. For his part, if the purchaser has doubts about the projections, he will be paying the amount he believes the business is worth up front and will pay additional amounts only if the seller’s predictions come to fruition.
However, an earnout agreement can only be used if the seller is willing to continue working for the company during the period of the earnout. He can’t walk away from the company after closing the sale, since it will be up to him to reach the financial benchmarks.
Here’s how it can work in real life. Last year, the owner of a New York area software development business was selling his company. His innovative software was licensed to many major publishers, resulting in phenomenal growth over the course of several years. The software’s success caught the eye of a substantially larger software company trying to make inroads in this field. When the owner of the smaller business was approached about selling his company, a major sticking point was the purchase price. The seller expected growth to continue at close to the same levels that the business was currently experiencing. The purchaser, however, felt that the company’s growth would stabilize within a year or two. The purchaser offered $3.4 million. The seller felt the company was worth an additional $435,000. This was an ideal situation for an earnout agreement. The two sides agreed to a contract that stipulated that $3.4 million be paid on closing and the difference be paid after two annual milestones were achieved by the company. In addition to the earnout agreement, the seller also entered into an employment contract (he was paid a salary), the length of which was equal to the length of the earnout agreement. Under the employment contract, the seller retained salient control of the business in order to ensure that it would be run in such a way that the milestones could be reached. How has it worked out? The seller successfully hit the first-year growth milestone, and is on his way to reaching the second milestone. Both parties expect he will easily earn the extra payments, and both the seller and the purchaser of the company are happy.
Although the most common reason to use an earnout is to close the gap between a buyer’s and seller’s desired purchase price, there are other uses.
On occasion, purchasers (and sellers) find an earnout an attractive way to finance the purchase. If a buyer lacks sufficient cash to pay the entire purchase price at closing, he could use an earnout as a way to finance the remaining amount. From the seller’s point of view, an earnout agreement can be an attractive alternative to employing a promissory note and hoping the purchaser can make the payments on time. The seller continues to operate the business during the earnout period, effectively ensuring that enough revenue is being generated to cover the additional payments to himself. The benchmarks for the seller under an earnout agreement in this situation would be different than in cases where the seller and purchaser disagree over the purchase price, since the worth of the business has already been settled.
There are also transactions where the purchaser desires to maintain the management structure. The purchaser understands that the seller’s management is responsible for the business’s success and wants it to stay in place, either for a specific time period or indefinitely. With a new owner at the helm, there can be resistance by the management team to remain or to work as hard as they did when the seller owned the business. Incorporating an earnout into the transaction with incentives to the seller and management team can motivate the team to work as hard as they did when the seller owned the business. The Crucial Issues The most important issues confronting a seller or purchaser when negotiating an earnout are determining the benchmarks and defining how the base amount and benchmarks emanating from the base will be calculated.
To determine the benchmarks, it’s necessary for the parties to determine what goals are necessary in order to justify the additional payments under the earnout agreement. Usually, the gap between the parties’ prices will be the earnout amount. Negotiations between the parties will solidify what the benchmarks should be and the period of time in which the earnout should be utilized. The typical time period of an earnout is about two years.