Tips for Negotiating an Earn-out
The other day I met with two entrepreneurs running a graphic design business generating $1 million in revenue per year. They were in the final stages of negotiating a deal to sell their company to a large multinational marketing services firm.
The buyer was offering $900,000 up front, which amounts to four times my friends' pre-tax profit. The buyer had also offered my buddies an 'earn-out': another $700,000 if they achieved a sales growth milestone over the next three years as a division of the acquiring company.
My friends thought they were selling their company for $1.6 million, but if statistics on earn-outs are correct, they will likely never see the second payment.
'Less than half of entrepreneurs stay for the length of their earn-out,' says Rick Heinick, senior partner at Stamford-based Schaffer Consulting. 'A lot depends on the entrepreneur. If the earn-out looks at all doubtful, and they have an idea for another business, they're not going to stay around for three years.'
Here is advice from Heinick and Gary Shamis, managing director at Cleveland-based accounting and advisory firm SS&G, to business owners for negotiating an earn-out agreement they can stomach.
1. Ask for a seat at the table when the goals are being set
Most earn-out agreements are drafted in isolation by the acquiring firm and presented to the seller as a 'fait accompli.' Instead, Heinick suggests business owners ask to be involved in setting realistic post-sale goals for the joint company.
2. Agree to goals that reward integration results
Using an earn-out tied to your company's profits as a division of the buyer encourages the business owner to prioritize profits of his/her division over the integration of the two entities.
For example, let's say you use Peachtree for accounting, and the buyer uses SAP. The last thing you want to do is waste time changing accounting platforms when you have an earn-out number to hit, yet having one bookkeeping software program would accelerate integration. The same trade-off is played out in decisions around the sales team, product lineup, real estate, marketing and so on. Integration trade-offs can be the enemy of short-term profit and can create serious tension between the selling entrepreneur and the buying firm.
Instead of signing up for an earnings goal exclusively, Heinick suggests you ask the buyer to consider also including goals that measure the performance of the integration, such as cross-selling targets, revenue in a new geographic region, number of new customers, etc.
Shamis adds: 'As opposed to profits, earn-outs can be based upon the acquired owner serving their time, client retention or earning a patent, etc.'
3. Sprinkle goals throughout the earn-out period
Three years is a long time to wait to get paid, yet most earn-out contracts are heavily weighted to the last year of the agreement. According to Heinick, both buyer and seller would be better served by negotiating smaller payments throughout the earn-out period that reward results along the way.
Shamis adds: 'We have lots of experience in entrepreneurial businesses selling to large corporations (both private and public), and we seldom see these earn-outs actually cash out. So the advice is simple: try to increase your up-front payment and put less in the earn-out.'
The three points above assume both buyer and seller go into negotiations with a spirit of flexibility and willingness to work together—which takes me back to my friends with the offer to sell their graphic design business for $900,000 with a possible $700,000 earn-out tied to hitting revenue goals. After our chat, my mates asked the would-be acquirer for input on structuring the earn-out agreement, but my friends were told that the acquirer has a standard formula for earn-out contracts from which it was not willing to stray.
Given the rigidity of the buyer, the track record of earn-outs and the natural tension between integration and maximizing short-term sales, I don't imagine my friends will last six months post-sale. But at least they know they're selling their business for $900,000, not $1.6 million.
JOHN WARRILLOW | Columnist | Sellability
John Warrillow’s new book, The Automatic Customer: Creating a Subscription Business In Any Industry will be released on February 5, 2015. John is also the author of Built to Sell: Creating a Business That Can Thrive Without You and the founder of The Sellability Score, a company dedicated to helping business owners improve the value of their company.