Maximising your Exit: Choosing Between Earnouts and Upfront Payouts When Selling Your Business
Walter Adamson
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When selling a business, one of the most important decisions a business owner must make is whether to seek a 100% upfront payout or to accept a partial upfront payout and an earn-out payment. An earnout is a deferred portion of the purchase price contingent on the business achieving specific performance metrics over an agreed period - the earn-out period.
Some say that earnouts "are the enemy of the entrepreneur", which says more about how to get them wrong rather than it being an inherently bad option.
Both options have advantages and disadvantages, and choosing between them requires careful consideration of various factors. In this article, we will explore the pros and cons of each option, as well as factors to consider when making this decision.
The context of this article is when an owner has the opportunity to sell to a strategic buyer. That is, when a buyer is convinced that the transaction will deliver more value than the historical sum of the parts. By definition, this additional value is in the future. The buyer will seek insurance over the promise of future value the seller promotes.
This insurance becomes even more critical when the buyer is considerably larger than the seller, and the buyer team doing the transaction has to sell it up the line to unemotional senior executives and even members of the Board.
Advantages and Disadvantages of Earnouts
Where there is uncertainty about the future performance of the target company earn-out payments are common in M&A transactions. The basic idea is that the seller agrees to receive a portion of the sale price based on the business's future performance - often financial performance but not exclusively.?
I think the best way to think about earnouts is that they bridge the valuation and expectation gap between buyer and seller which, in theory, will be narrowed over the earn-out period.
I've experienced sellers who react emotionally and negatively to the suggestion of an earnout, e.g.
However, an earn-out provision is a rational point of negotiation that can ultimately satisfy both parties' risk profiles and valuation expectations.
Earnouts should be negotiated to be advantageous for both parties, in line with the transaction yielding a 1 + 1 = 3 result. This is a critical outcome that an experienced sell-side M&A firm can deliver. For example:?
Concerning the negative emotional reactions mentioned above - a strategic buyer will commit resources to accelerate the business growth of the target company. Therefore, a fully-priced offer with an acceptable earnout should ultimately deliver a substantially higher transaction value for the seller.
However, there are also several disadvantages to consider regarding earnouts.
One major drawback is uncertainty – since the payout is contingent on future performance, some risk is always involved.
Additionally, sellers may feel like they lack control over the business during the earnout period, as they may be required to work within new processes and constraints, which are part of the buyer's modus operandi. This is why it is common for mid-market companies to be stand-alone entities post-closing - to give more certainty to the seller's control over the earnout.
Advantages and Disadvantages of Upfront Payouts
Upfront payouts offer sellers immediate cash flow and certainty, which can appeal to those looking to exit the business and move on quickly. The seller knows the amount and timing of the payment and is then free to pursue other opportunities without further obligation.
For example, according to the Wall Street Journal, over 70% of tracked earnout payments had an earnout period of 1-5 years, which may not suit your goals.
However, there are also some disadvantages to consider. The biggest drawback is that the payout may be lower than what the seller could have received with an earnout, and in a buyer's market, this is certain to be the case.
It makes sense that potential buyers will assume less risk or seek to transfer risk in a less-certain market. Therefore economic and industry cycles also play a crucial role in determining the discount applied to future earnings to determine a purchase price.
Upfront payouts:
Factors to Consider When Choosing Between Earnouts and Upfront Payouts
Let's say that your business has strong growth potential (which you have validated to the buyer), you are in a seller's market, and you are offered an upfront price that meets your expectations. Then it may be very appealing to take it, irrespective of whether or not you continue to work in the business.?
On the other hand, if the industry is experiencing rapid change or disruption, the buyer will be unlikely to offer a fully-priced upfront payout.
Suppose the buyer is financially stable and has a long-term outlook for the business. In this case, they may be more willing to offer a larger upfront percentage since they are confident in their ability to achieve future performance goals.
On the other hand, if the buyer is more focused on short-term gains or has limited resources, they will want to transfer more risk to you through a lower price or a higher percentage of earnout payments.
There may also be industry-specific or business model reasons which make earnouts the common practice, e.g. for businesses dependent on the retention of clients, and employees, industry accreditations tied to specific employees, or contracts that have nominated parties required for their continuity.
Being able to effectively communicate your intimate knowledge of your business, the industry sectors, and the economic tailwinds and headwinds will play a significant role in arriving at the right negotiating stance on payout versus earnout.
Structuring Earnouts and Upfront Payouts
Once you have decided on the payout-earnout balance, then it is critical to negotiate a deal structure that supports your preference.
For example, an earnout can be structured as a percentage of future revenue or profits or based on achieving specific performance metrics such as customer retention or product development milestones. Similarly, an upfront payment can be structured as a lump sum or a series of payments over time, and possibly including escrows.
Your negotiating power revolves around the following key questions:
The key is to find a structure that aligns with both parties' interests. This is where M&A firms with expertise in earnout structuring and negotiation can provide indispensable value in formulating the purchase agreement.
How to Decide the Best Metrics for Earn-out Calculations
When structuring an earnout, choosing the right metrics for calculating performance is crucial if you are to avoid the earnout becoming your enemy. This choice can be challenging since both financial metrics and non-financial metrics can impact a business's success, and some you will more control over than others.?
Some factors to consider when choosing earnout metrics include the following:
Common earnout metrics include revenue growth, EBITDA, customer retention rates, and product development milestones. Each metric has its own pros and cons – for example, revenue growth may be easy to measure (good for the seller). Still, it may not accurately reflect profitability (not good for the buyer).
At the same time, product delivery milestones may be harder to measure (good for the buyer) but depend on investment and resourcing decisions by the buyer (not good for the seller).
EBITDA is a financial metric that may often suit both buyers and sellers. It is less vulnerable to accounting manipulations and can provide a clear picture of the company’s ability to generate earnings from its core operations, excluding non-operating items such as interest, taxes and non-cash expenses.
On the other hand, EBITDA does not account for changes in working capital or capital expenditures. It may not be the best measure of financial health in industries with high capital expenditures or those with significant fluctuations in working capital.
Takeaway - clarity and preparation are essential
Balancing earnouts and upfront payouts is a critical element of your sale transaction.
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Benefits of earnouts:
Disadvantages of earnouts:
While both options have advantages and disadvantages, the key is to consider your personal and business goals, the buyer's goals, resources and objectives, your customer's expectations, and the market and economic conditions when negotiating your position.
? THE BIG IDEA:?The deal terms for an earnout should be clear, simple, and fair.
The key, as always, is to start preparing your business to be sale ready now, and at least several financial cycles before you anticipate a transaction. Focus on improving your Quality of Earnings, and the bankability of growth, and you will be in an ideal position to achieve your desired deal structure when the time comes.
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This Week's Reading
Two articles from my reading list to help you grow and exit successfully.
Article 1: Four Reasons Earn-outs Blow Up
Earn-outs, while promising to facilitate the benefits of the merger, can lead to adverse outcomes in many instances, making them a problematic tool for sellers, says the author.
In fact, based on interviews with over 100 owners who have sold their companies he has concluded that earnouts are the enemy of entrepreneurs. The horror stories recited include include unexpected expenses, inadequate financing, and poor communication from the buyer, which significantly affected the ability of the seller to achieve the set targets, leading to a considerable shortfall in earnings.
For example, if the buyer's CFO charges certain head office expenses to all their divisions, it can significantly impact your P&L statement. If your earn-out goals require investment to help you reach them, and your acquirer fails to fund your division, it will become difficult to hit your goals, particularly if they are tied to sales increases.
To avoid earnout problems, the author recommends negotiating clear and specific targets, timelines, investment commitments, and overhead distribution commitments (or adjustments to the targets).
Source: Forbes.com
Article 2: Earnouts Bridge the Expectation Gap Between Buyers and Sellers
The use of earnouts in M&A deals is increasing, most likely in response to the uncertain economic environment. Buyers are taking a more conservative approach to valuation, and offering earnouts to reduce the potential risk of underperformance.
? However, earnouts are more prone to future disputes, and clarity around applicable metrics, earnout periods, payout formulas, measurement standards, and post-closing covenants is crucial to avoid future disputes. Clarity is the best protection against future disputes when using earnouts as a potential solution to bridge the gap between buyers’ and sellers’ expectations.
1. What are the potential benefits of using earnouts?
Answer: Earnouts can offer a way for buyers to realize the proceeds they want while giving peace of mind to the seller that they will only have to pay an increased purchase price as long as the business performs as expected.
2. What are the potential risks associated with using earnouts in M&A deals?
Answer: Earnouts are more prone to future disputes. The clarity around applicable earnout metrics, earnout period, payout formula, measurement standard, post-closing covenants, and assumptions that are made should be spelled out to avoid future disputes.
3. How can parties protect against future disputes when using earnouts?
Answer: Clarity is the best protection against future disputes. Parties should clearly define the applicable earnout metrics, earnout period, payout formula, measurement standard, post-closing covenants, and assumptions that are made in the earnout agreement. They should also consider including dispute resolution mechanisms, such as mediation or arbitration, in the agreement.
Source: TheMiddleMarket.com
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Adviser to over $2 Billion in Business Value | Speaking on Equity Incentives and Ownership Succession | Trout Angler and Founder
1 年Walter what has been your experience with owners who accepted an earn out? We’re they able to maintain their commitment to the business after the change in control? Does the buyer tend to “takeover “ and change the rules of the game?