Some of my clients tell me they would never accept an earnout, but then go on to say how they believe the historical earnings don’t tell the whole story and that a buyer needs to believe the company will grow in the future. In other words, pay more. Unfortunately, many buyers will say, “I don’t quite believe you, prove it”. And that’s an earnout. Here is how to tell if an earnout makes sense when you sell your business.
When are Earnouts used?
An earnout is contingent future payments based on performance milestones. For example, in a simple earnout arrangement an extra payment of $100,000 to the seller may be “earned” by growing the company by an additional $1 million in revenue in the 12 month period after the close of the transaction. Earnouts are used when there is a difference of opinion on what the earnings will be in the future. The buyer says, essentially, “show me”. Earnouts are well known in the technology sector; however it really has more do with high growth scenarios than technology.
Business are Bought for Future Earnings
In looking at Earnouts, it is useful to remember that what a buyer really cares about are future earnings. Since we don’t know what future earnings will be, we generally use historical earnings for valuation. Earnout discussions naturally arise when there is a significant difference between historical earnings and future projections.
Let’s look at a few scenarios of historical vs. projected earnings.
Scenario One – Stable Earnings
This company has a stable history and a believable projection. It isn’t hard for anyone to believe that projection. In other words, the risk is fairly low, and the seller should not expect an earnout.
The purchase price in this case should be comprised of cash and possibly a note, but unless there are other risks, the note shouldn’t be contingent on revenue or earnings – and there should not be an earnout.
Scenario Two, Supported Growth
In this scenario it is also easy to see where earnings are heading – up. In other words the projection of future growth is clearly supported by historical trends. However there is often some discussion about who is going to benefit from the growth. A seller may say, “You can see what will happen, so I want to base the purchase price on a high multiple, or possible use next year’s earnings”.
A buyer, on the other hand, may say that if the company grows, it will be because of his effort after he buys the company, not the sellers. After all, he certainly isn’t buying it to give all the earnings to the previous owner.
A smart seller will counter this by explaining that much of the future growth is because of the foundation he has built. The website, reputation, product, service, etc. have all come to together to build momentum that would be difficult to stop. However, what he is also saying is, “Just trust me on this”. No one likes to bet hundreds of thousands or even millions trusting someone you recently met, so earnout discussions start.
In this type of scenario, an earnout could look like the following:
A “base price” of cash and notes is calculated using historical performance, and an earnout is structured based on the company hitting certain targets. The target may be a revenue or earnings milestone or just about anything that makes sense. The next blog post will cover typical earnout stuctures.
Scenario 3, Unsupported Growth
We often (too often) see a scenario where the company doesn’t really have an upward trend, yet the business owner believes there could be a lot of growth opportunities. For example, the owner may say, “I never got around to putting up a website but if you built a website and sold products online, sales would double.” In this case the buyer does have a pretty good case to say, “Well, if I spend the money and time to build the website, then I should enjoy the rewards”.
Sometimes we can negotiate an earnout in this type of scenario, but it really depends on the situation and why exactly the seller believes growth is inevitable.
Scenario 4, Recession Proofing a Transaction
Although earnout agreements are mostly seen in growth companies, we’ve also seen it a few times in protecting the buyer from further decline during the recession. Many companies have seen a retraction of sales and earnings from the time before the recession, and that is just fine with buyers – as long as the performance has stabilized. We’ve seen buyers, fearful of further decline, set a purchase price on a lower “base” number, then set up an earnout target of simply staying put. In other words, if the business does the same in revenue and earnings in the future, then additional payments are made to the seller. If the business slides some more, then the seller gets the “base” price that was somewhat lower.
In the next few blog posts, I’ll cover how frequently earnouts happen, and how they are typically structured.