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Top Tips: Making your Earn-Out Work

September 21st, 2015

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 may-01By Gordon Blair

Over two thirds of deals involving owner-managers include earn-outs. In a transaction with an earn-out, the buyer will usually pay most of the consideration on completion for 100% of the shares of the business. The rest of the consideration will be earned in a period after legal completion depending on whether or not certain financial targets are achieved. This is different from “deferred consideration”, where the sellers are guaranteed payment at a future point in time regardless of the performance of business being sold.

Earn-outs are a necessary part of many transactions because they satisfy two main objectives. For a buyer, it is about mitigating risk. It usually helps with management continuity, acts as an incentive and means that if the business under-achieves its forecasts, they pay less. For a vendor, it bridges a valuation gap from what the purchaser is prepared to pay on legal completion and what is an acceptable price for the vendor.

If you want to ensure that you receive the full value for your earn out, you need to bear some things in mind.

  1. Can an earn-out actually work in my case?

As a seller, you need to have the ability to earn your earn-out. If a purchaser wishes to integrate your business in to their own operations rather than allowing it to be run as an autonomous subsidiary, it will be very difficult to structure an earn-out. Post-deal, a seller must retain a reasonable degree of control if the deal is going to work. So earn-outs are appropriate where the sellers are willing to continue running the business day-to-day, the business is growing and the buyer is not seeking to immediately unlock cost-saving synergies. In a management buy-out, the sellers are far better off seeking a minority retained equity stake rather than trying to structure an earn-out.

  1. “Carrot vs stick”

You need to be realistic about the targets to be achieved. Most earn-outs are based on the achievement of growth – doing better than last year. If you are over-optimistic in your forecasts, you will have little chance of achieving your earn-out. The most successful earn-outs act as genuine incentive rather than a sword of Damocles.

  1. Which line is it anyway?

Financial performance can be measured a number of ways. The easiest is revenue, as there is less room to manipulate it. As a seller, revenue targets can be attractive unless you have started selling much higher margin goods or services. Buyers rarely like revenue-based earn-out targets as a seller can “buy” turnover at the expense of profits and cash generation.

Targeting gross margin can sometimes work, but most commonly an earn-out is based on the achievement of Earnings Before Interest and Tax (EBIT) or EBITDA. Don’t use Profit Before Tax (PBT) or Profits After Tax (PAT) as the funding costs (which affects interest) as tax rates can vary and mask the real operating performance.

  1. Invest the time with the buyer in setting the rules

The devil is in the detail. Once a buyer has bought your business, they are in the stronger negotiating position if there are any matters which are ambiguous or require opinion when calculating the earn- out. The sale and purchase agreement must contain detailed schedules setting out everything which should be included, or excluded in the calculation.

  1. Details checklist:
  • Set a reasonable time period: one or two years is best, three at a push. As you don’t know what the future holds for the business and the acquirer, any longer could tie you to misery.
  • Negotiate a sliding scale: this means that if you narrowly miss a target, you will still receive some of the consideration, and you might get more for over achievement if you have negotiated that as well. Consider whether or not you want to have the opportunity to “catch up” in a second year if the first year falls slightly short.
  • Avoid a “double test” where you need to achieve both revenue and profit target as this complicates matters, reduces your ability to earn and can be unfair if you only achieve one of the two targets.
  • Define EBIT (Profits) very carefully: for example, exclude any central “group” charges and ensure management remuneration / bonuses remain under your control. People often overlook accounting policies: make sure they are the same and defined as yours, not the buyers.
  • Try and gain extra credit: ensure that any revenue and profits generated as a result of being part of the acquirer (e.g. from their customers) or any cost savings (e.g. lower costs of goods from the acquirer’s purchasing power) count towards your earn-out.
  • Make sure you are given the time to run the business: don’t get sucked in to non-earn-out activities such as taking over another division within the acquirer.
  • Ensure your service contract runs three months longer than the earn-out period: this means you will still be in the business with access to information when the final consideration is being calculated.
  • Get the form of consideration right: cash or loan notes? It sounds technical, but the key decision is whether you want to pay your capital gains tax sooner (at the prevailing rate) or defer the gain to later. Most sellers who qualify for entrepreneurs relief at 10% tend to opt to pay now in case the rate changes.

 

Gordon Blair Gordon Blair is an Academy 88 member and has been advising owner managers on buying and selling businesses for 20 years. He also undertakes non-executive director work, where one of his most successful roles was with a championship winning Formula One Team. At successcf.com, under his alter ego, Dr McDeal, you can find more hints on earn-outs and other aspects of deals.

 

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