Using an earn out can benefit both buyer and seller of a California business purchase. A recent question by a buyer participating the BizBen ProBuy Program about the best way to structure a business earn out prompted me to ask a panel of BizBen Resources how they would deal with the buyers question on earn out structures.
The specific question the buyer asked was: "Is this a good time for buyers and sellers to use earn outs so if the business value has slipped because of the economy, the seller stands to gain when things get better, and the buyer can get a good business at today's discounted price, then pay for its recovered value from proceeds of the business? Also, how do you recommend structuring the earn out?"
Below are answers from our panel of BizBen Resources:
"An earn outs is a broad term that attempts to realize future value in a transaction and if the opportunity is identified and correctly incorporated into a deal structure, a seller can extend and realize additional wealth gathering and employee benefits in addition to mitigating taxes. However, much depends on the business, experience and preparation, circumstance and buyer recognition. Generally, earn outs are not workable solutions for very small businesses say under $5M in revenue because they simply don't have the required built-in financial reporting systems necessary to not only prove there will be future benefit but to also monitor and measure the results on a systematic ongoing basis.
The most important aspect to realizing a benefit from an earn-out is recognition by the seller that there will be future value in the business at a later time and it's surprising to us how many Seller's don't recognize this fact because they seemed to be focused only on cashing out. In working with a seller, during the interview process we introduce them to our 3 step process; a process designed to uncover relevant facts that can lift and/or maximize the value of the business from the perspective of the buyer. It's most important to identify this opportunity before the business is marketed because the business needs to be analyzed and benchmarked to isolate and identify the specific opportunity to maximize the total value of the transaction. Some examples of opportunity include new customers, advertising program, product development etc. This is most important because after closing, it is necessary to track the metrics of the opportunity against established benchmarks so the earn out can be easily calculated. For example, in working with a recent manufacturing client, we learned that over a two year period, the company invested over $750K in R&D and new equipment leases for a new product due to hit the market in the upcoming year which they projected into $1M in orders for coming year. While we prepared our marketing plan and executive summary, we asked the company to contact their clients and request purchase orders and projections for one year and they managed to collect $1.425M in orders which we promptly converted into an earn out to recoup the investment plus a bonus.
Now the question becomes: "how to get paid and for how long". We find it more effective to determine and test several deal scenarios and structures with our client in order to assess their risk tolerance, confidence and their belief that the earn out can be achieved -- after all no one knows the capability of the earn our more than the seller. This also allows us to be an advocate for the buyer because an earn out will not be incorporated without the buyer recognizing that this future value is incremental to his sweat equity.
This is a long way around to answering the proposed question but in this never-to-be-experienced economy, it seems plausible but dicey that an earn out could be effectively structured unless the components can be isolated so the gains can be directly attributed to economic recovery and not due to the buyer sweat equity. If it is a component to the deal structure, another factor unique to this economy is bank financing. Essentially subordinating, would the bank agree to relinquish these future earnings to the seller? It takes experience, creativity and a team of trusted advisors to effectively construct an earn out into a deal structure so that it can be monitored and measured in a manner that is believable and acceptable to both the seller and buyer, otherwise there is room for disagreement, breach and possibly litigation."
Finding lending sources is difficult these days due to the shortage of capital available and stringent requirements imposed by the lender due to the Fannie Mae/Freddie Mac debacle. To compensate for this, sellers have been asked to take back a larger portion of the desired sales price, expressed and a loan secured against the business assets. We have configured several deals where this loan payment is expressed as an "earn out" with an associated performance contract with upside bonuses. This vehicle has advantages to both the Buyer and Seller.
For the Seller: 1) Allows them to achieve a greater value for their business 2) Has some security for the note against the business assets 3) Has some Potential Tax relief both in terms of capital gains on the sale and payment of the note as opposed to W-2 salary.
For The Buyer: 1) Less cash outlay up front 2) Security that the Seller would pay attention to the business as they had skin in the game 3) Upside potential as the Seller is motivated through potential bonuses.
One of our biggest successes is a supply company that had gross sales of $1.8M/yr. After the sale, the following year sales jumped to $2.6 mil. The seller had his note paid off early and achieved an extra $50k in bonus money.
A Win-Win situation. BTW: They are still working together and the Seller has cut 5 strokes off his golf game.
Since sellers want a lot of money based on prior performance and buyers are afraid there may never be a recovery, earnouts is a way to bridge the gap. Earn outs are usually based on either increase or decrease in sales or changes in net profit. Earn outs based on net profit are impossible to us unless the seller stays with the business and has control over the bottom line. Gross sales or gross profit earnouts can very successfully work.
I recently received a 10 page report from an attorney friend of mine laying out all the possible ways to do this. The choices are more then one would imagine. Most important is that when negotiating an earnout in a deal, you must have representation on both sides. A dual agent can not be netural in this situation and the legal consequences are dangerous for an agent. Thi is because what is good for one is bad for the other.
Get good representation when doing these negotiations. That representation will have access to a full library of earn out possibilities.
Earn out deals make sense in today's market. Earn outs also make sense in "good times". They can make the most sense when a manufacturing, distributing or service business has a good business model, idea, or product that hasn't been marketed to its potential.
First a seller needs to be realistic on his business value. This value is closely tied to the businesses financial performance. If the economy has brought the income of the business down, or the business simply is too new to meet its potential, the seller can not achieve the price he believes his business is worth. A earn out sale is the best solution for both parties. The seller may be able to realize his price, and the buyer only pays more if the business reaches pre-agreed upon levels of performance.
Structuring Earn Out sales typically are unique in each circumstance. It is a hard question to get specific on without knowing about the buyer, seller and transaction. With that said, a few conditions need to be incorporated in every earn out.
1. The seller needs to be involved with the business after the sale at some level. The smallest level of involvement would need to allow the seller to verify the business performance after the sale to see if earn outs are reached. The largest level of involvement would have the seller co-managing the business along with the buyer so the seller has a chance to help the business reach the predetermined levels. When a seller is involved in the day to day management of the business after the sale, he typically will have some type of salary in addition to the earn out. The salary should not be large or burdening to the business as the seller should get his reward in the earn out not the salary.
2. Set realistic goals to reach. Be very specific on what has to happen in order for the seller to get paid a piece or all of the earn out money. There can be and should be steps of pay outs to the seller as the business hits certain marks. These certain levels or marks can be other things besides income levels. Maybe acquiring a number of new accounts, employees, reduction of expenses, etc.) Also be detailed on the pay outs to the seller if levels are met.
3. Dates need to be in place along with whatever the agreed upon business performances are, and the agreed upon pay out is. Set an expiration date for each and every level of pay out. These deals need to eventually expire. In most cases they shouldn't be more than 2 years. More often not more than 1 year. Again individual transactions and their circumstances will dictate this too.
If you have a question regarding buying or selling a California small to mid-sized business and would like to have it answered in a future BizBen Blog Post or have interest in the BizBen ProBuy Program please feel free to phone BizBen at 925-785-3118.