Acquiring an existing business is one of the best ways to start, or expand, your operation. You’ve decided it strategically makes sense and have a target in mind. At a high-level, everything looks good. The next step is to sit down and pour through the financials for the deal. As you begin your due diligence, one of two scenarios will play out.
- The target is well established and has had sound professional advice in the past. This makes establishing a ‘fair’ purchase price and structure fairly simple
- The target’s financial statements aren’t as thorough, or the seller has a less established track record for the business
As the buyer, strongly consider negotiating an earnout provision into the letter of intent and/or the asset purchase agreement. This is particularly important in the second scenario. Typically, an earnout provision allows the purchase price to be adjusted post-closing based on achievement of set revenue goals or other milestones. It also builds in a certain amount of protection against fraud for the buyer against the seller.
Earnouts can benefit sellers as well. Sellers can use an earnout provision to maximize the purchase price, particularly when the business being offered would benefit from increased marketability and confidence that an earnout provision can provide.
A typical earnout may involve anywhere from 10 to 50 percent of the purchase price being deferred over a three to five-year period after closing. The financial targets used in an earnout calculation may include revenue, net income, EBITDA or EBIT targets, and the selection of metrics also influences the terms and conditions of the earnout. Sellers tend to prefer revenue as the simplest measurement, but revenue can be boosted through business activities that hurt the bottom line of the company. On the other hand, while buyers tend to prefer net income as the most accurate reflection of overall economic performance, this number can be manipulated downward through extensive capital expenditures and other front-loaded business expenses. Some earnouts may be based on entirely non-financial targets such as the development of a product or the execution of a contract.
In my experience, the use of a properly-worded earnout at the onset of negotiations can provide enough confidence for both parties to move forward with a transaction.
Four Keys To Keep Your Earnout From Backfiring:
- Set clear expectations. Each party must know what they are responsible for and how it can affect final payout.
- Don’t be short-sighted. Make sure that your seller takes a long-view and continue to focus on development and investments, not just a short-term goose in sales.
- Know your goals in advance. Determine if your target is a cash-hungry fast-growing business where you will need to reinvest resources and sacrifice short-term performance.
- Build the right team early. Involve your accountants, lawyers and executives early in your decision-making process.
If you are considering starting a business, or expanding your existing business through acquisition, and want help with your due diligence, structuring or closing your transactions, contact Bill Williamson.