Five steps to getting the icing on the cake

POSTED BY Andrew Wallace
11 March 2014

posted in Earnout | Contingent consideration



You’ve been negotiating the sale of your business and while you’re confident that it’s going to continue to grow as you’re projecting, the buyer just isn’t sure and you’re too far apart on price to reach agreement.

To break the impasse, the buyer suggests an earnout; that is, part of the purchase price be hinged on the future performance of the business, payable if certain financial or operational targets are met. But, before you put your money where your mouth is there are five critical things you need to do.

The scenario outlined above is a common example of where earnouts are used. They’re often found where a business has limited operating history, where new product lines have recently been introduced, where the performance of the business depends on key customers sticking around, or where there’s not a lot of stability in the industry in which the business operates. Basically, they can be a useful tool to get a deal over the line wherever there’s a lot of uncertainty around the future performance of a business.

From a buyer’s perspective earnouts can be a worthy exercise in risk management. They get to conserve their cash and only pay up-front for what’s bankable. An earnout can have strategic advantages too, for example by smoothing the transition to new ownership by keeping the seller working in the business for a period post-settlement.

As a seller, under an earnout you’re effectively trading the certainty of less money up front for the chance of more money over time. If in principle you’re comfortable doing so, it’s critical that you:

  • Get the highest possible cash price up-front. In the worst case scenario this is all you’ll be getting. Think of the earnout payment as the icing on the cake. If you’re not comfortable with the upfront price, keep negotiating.
  • Figure out the buyer’s motivations for buying the business and what they’re likely to do with it post-settlement. You can’t set up a solid earnout structure without understanding this.
  • Use a more objective measure, such as sales, as the target rather than something like net profit. The latter is more subject to manipulation. If the buyer insists on any sort of net figure, there are various additional protections you need. It almost goes without saying too that whatever the target, it should be achievable. This is not the place for aggressive stretch targets.
  • Think carefully about the key determinants of whether the target will be met and what could push the business in an unintended direction, and what you can do to influence those things. You’re in a much stronger position if you’ve still got a role in the business post-settlement. However, even if you’re not, there are a range of things you can do to protect your position.
  • Get experienced accounting, tax and legal input. There’s a lot of detail beyond the scope of this article that needs to be carefully thought through and documented to make sure everything works as you intend it to do.

You can’t foresee everything that might happen, and circumstances and motivations change over time. Ultimately, if buyer and seller incentives are aligned, the earnout target is clearly defined and appropriate protections are in place, in a carefully drafted agreement, you’ll go a long way to maximising the chance of a successful outcome.

This article was first published in the Your Law column in the Sunday Star Times on 2 March 2014.

POSTED BY Andrew Wallace
11 March 2014

posted in EarnoutContingent consideration



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