As we have examined before, earn-outs can be an important deal making tool when a company’s expected growth is potentially greater than its history has shown. However, because of our COVID-19 impacted business world, constructing a safe and workable earn-out right now requires more and more diligence and M&A experience than ever before.
So what does an earn-out do? Essentially it transfers some of the risks of a company’s future earnings away from the buyer and places a portion of the potential risk on the seller. And that is where the real issues exist with any earn-out.
If you are planning to stay with your company, and if you will have control over the items included in the earn-out, this type of deal could earn a substantial reward. However, if you are not retaining control over key areas, you could be negatively impacted. So, as you can see, it is wise to have sound advice while you consider an earn-out scenario.
This is especially true in today’s COVID environment.
Earn-outs have been used for decades (if not centuries) by dealmakers to bridge the gap between a seller’s expectations of future growth and a buyer’s desire to reduce the risk inherent in the projected growth of any privately held company.
Here are a few of the key items you need to carefully consider if you are approached by a buyer with an earn-out (especially if you do not have professional M&A advisors at your side):
Now odds are good that unless you have bought and sold several businesses, you have not created or monitored an earn-out scenario. This is why we are suggesting so strongly that, especially in the current landscape, you need sound and seasoned M&A guidance and advice before agreeing to any earn-out program.
If you are being retained post-close, and if you have decision-making authority, crafting an earn-out is very plausible. You and the buyer can amiably agree on revenue, earnings and other financial measurements that, if trackable, can be very rewarding to you.
Non-financial goals such as key client retention and key employee preservation post-close are harder to quantify, but they are also workable if you have control over these relationships.
Where earn-outs get tricky is when the seller has left the organization, has no control over key decisions, and often very little ability to verify whether goals are being achieved or not. This is a situation you want to avoid as it leaves you at the mercy of the buyer and their advisors.
However, the reality in our current environment is that growth projections budgeted at the beginning of 2020 are now, seven months later, likely to be outdated. That still does not mean that your company is not as valuable as it was TO THE RIGHT BUYER (and with the appropriate deal terms).
Even during the best of times, every M&A transaction requires a large portion of faith on both the sellers’ and buyers’ part. This is truer now more than ever before. But what is also true is that if you want to achieve an optimal deal in today’s environment, you need sound professional exit planning advice.
And trust me you are not going to get that from your retired Uncle Larry who used to sell real estate….
You need a team to guide you. Generational Equity has the experience and talent to successfully close deals no matter what economic cycle we are in. Here is some proof for you:
Most importantly, as you consider your exit in today’s environment, realize that buyers will more and more aggressively be pursuing earn-outs to balance the risk equation. Although completely acceptable as a deal making option, you have to be sure that your financial goals are met so that the buyer does not take advantage of you and create an earn-out that is heavily loaded with incentives that are out of your control.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
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