Although I’ve been a business broker for years, I only recently just did my first earn out. For those of you who aren’t sure what that is, it’s when a portion of the sale price is held back from the seller and he literally has to “earn out” the balance. In most businesses an earn out isn’t necessary but there are certain businesses where it makes perfect sense. The business I sold was a commercial janitorial business. The seller had very few accounts and was asking top dollar for the business. The buyer was willing to pay top dollar if the seller would guarantee that the business would perform equally as well when he took it over.
I have to admit when we first started this none of us, the seller, myself nor the two buyers, had a clue what the earn out should contain. I proposed that they seek out the advice of an attorney since one of the buyers was a CPA and he didn’t know. From what I can now ascertain, the best earn outs are not too long and based on gross earnings. The longer the earn out, the more chances something will go wrong. Most sellers are not too keen on having to stay involved in the business, so they might dismiss an earn out before getting all the facts. Having an earn out doesn’t mean that you have to stay involved in the day to day operations of the business. It simply means that if all hell beaks loose and something catastrophic happens in the business then the seller, who has been doing this successfully for years, can step back in and get this thing on track again. In our case, our earn out was based on the net profit.
Having an earn out based on the net profit is more complicated, how can the seller trust that the buyer will run the business as efficiently as he did? In our case we fixed and capped the operating expenses at the same levels that the seller sold the business at. This way it didn’t stop the buyer from running the business as he see’s fit, but also protects the seller from the net profit being lowered due to different operating styles. Everyone in my deal was intelligent and was interested in not having the document cost a fortune to construct. They found some example documents and began working out the most difficult points without an attorney so that when they did bring it to the attorneys for they’re blessing it was simple, fast and it saved them thousands from going back and forth trying to agree on the fine details.
The most difficult part of the document to agree on was the penalty of the earn out under performing during the life of the earn out. The buyers perspective was that they were willing to pay a premium, in this case 3.3 times net earnings. However, if the net profit went down during the quarter then the purchase price of the whole business was re-evaluated in that quarter. That works well in the first few quarters but it isn’t that simple a year later. The sellers perspective is that he should be penalized at the same rate as in the beginning, he feels that he is “earning his money out” therefore the risk should be going down over time. In our case, the buyers gave the seller opportunity to make back any potential loses in the next quarter, even beyond the earn out period.
Regardless of what is happening in a deal, it all goes back to what my first broker, that I worked for years ago said, "if you have a willing buyer and a willing seller, you will overcome all the obstacles in your deal."
About The Author: Christina Lazuric is an Orange County Business Broker who shares her broker experiences with BizBen readers and has had varied direct small business experience in the past but now assists small business owners sell their business and offers business buyers find their dream business to operate. Phone Christina direct at 949-257-7823.