When I talk to owners of businesses about a potential exit, I’m always asked about how they can take steps to protect their earn out and maximise price. For service or people businesses (such as those in financial planning), where much of the value is tied to its key personnel, the majority of acquisitions will include some form of deferral of the purchase price contingent on the future performance of the business (known as an Earn Out).
What is an earnout?
An Earn Out defers the part of the purchase price, so that the price is determined by reference to the future performance of the business. Often, performance is measured over a 1 to 2 year period (the “Earn Out Period”), although a longer or shorter periods are sometimes used.
What’s the risk for you as a seller?
The buyer will have a common interest with you in maximising the profitability of the business during the Earn Out Period, but often that mutual interest ends there.
There is lots of scope for potential conflict, but the most common key areas of tension are: operational control and short-term investment and costs.
As a seller you will want to boost the short-term profitability of the business by aggressively growing revenue and minimising investment and other costs. Whereas a buyer wants to invest in the business for long term growth.
Similarly, having left value invested in the business (via the deferred purchase price), sellers want to retain operational control during the Earn Out Period. On the other hand, buyers want to impose their own management style and control.
5 ways to protect your earnout
- Maximise control and influence. Make sure the acquisition documentation reserves the day-to-day operational control of the company to you as far as possible. A buyer is unlikely to be willing to give you full autonomy, but the acquisition should give you as much influence as reasonably possible.
- Your position. Entrench your position as an executive for the full duration of the Earn Out Period. It is vital that you remain in the business to protect your territory. Make sure that you can’t be sacked as an employee (other than for gross misconduct).
- Acceleration. Consider the circumstances in which a full acceleration of the Earn Out might need to be triggered. Circumstances might include a subsequent sale of the company by the buyer to a third party or a liquidation by the buyer.
- Ensure the buyer can pay. Make sure the buyer has sufficient financial strength that it will be able to fulfil payment obligations if the Earn Out is achieved. Consider requiring some form of guarantee – either from a buyer’s parent company or from the buyer’s bank. Alternatively, sellers often ask for money to be put into escrow or for the buyer to grant security over the assets of the target company.
- Be careful with metrics. How will the Earn Out be calculated – will it be by reference to revenue, net fee income or EBITDA (earnings before interest, taxes, depreciation, and amortization)? The higher up the P&L your benchmark, the more difficult it is for a buyer to manipulate the data through accounting treatment and provisions.
With an Earn Out, the details matter and forward-thinking matters. Keep these points in mind when negotiating your next Earn Out and you will be in a good position to maximise the value of your sale.