This is a continuation of our Deal Structuring series, check out Seller Financing & Deal Structuring 401 for breakdowns of real, recent deals
Now – let’s get to it!
Earnouts
So what is an earnout? Simply put, it is a method for a seller to receive additional $ based on the future performance of a business after a sale. Earnouts are frequently used to bridge a valuation gap between seller and buyer. Similar to seller financing, earnouts can help align incentives and encourage the seller to do everything possible to make a buyer successful as the new owner.
Earnouts have a mixed reputation as many see them as 1) having little to no chance of paying out and 2) a breeding ground for disputes or even worse, legal action.
From our perspective as experienced dealmakers, earnouts have worked well for a number of sellers and buyers.
Earnout best practice – avoid complicated metrics or formulas. You want an earnout to be black and white. Examples…
- – incremental revenue gain during 12, 24, etc. months close
- – retaining X% of accounts
- – winning X new accounts
We had a sophisticated private equity firm propose a complicated earnout structure in the summer of 2020 on a deal. It was to be based on Gross Margin %, by year, with corresponding payout percentages. This is where the potential for conflict can arise, as a buyer could include different expense lines than the seller to calculate GM %. That said, we have seen legal agreements that define direct vs indirect costs, in other words, the parties agree on how a profitability metric will be calculated. This could work..
Our advice? Keep it simple.
Couple points:
- Any earnout metric and payout should be 100% clear. We advise including a table in the Purchase & Sale Agreement, calculating earnout scenarios. If 2025 revenue is 105% – 109.9% of 2024 sales, the earnout is $X or %. If 2025 revenue is 110% – 119.9% of 2024, the earnout is $Y or %, etc.
- On duration of an earnout, it is rare to exceed 36 months. Most earnouts we negotiate between parties are 18 – 30 months. The logic here is that after this length of time, the buyer’s actions (good or bad) are really driving the business results
- An earnout will have multiple measurement points. Meaning, there will be a calculation at 12 months and then a separate calculation at 24 months. There could be no payout at 12 months but still be a payout at 24 months
- Parties can agree to any frequency of measurement points (monthly, quarterly, annually)
Rollover Equity
Sometimes referred to as a “second bite”, rollover equity means that a buyer is not buying 100% of a business. The seller and buyer effectively become partners, with the seller retaining a minority share of the business.
Couple points:
- The larger a deal, the more common to see rollover equity as a component of deal structure
- Parties may agree on a hold period and formula through which the entity will be valued in the future. We had a PE fund with an employee-owned model buy 90% of a business, then require the seller to sell the remaining 10% within 4 years. There was an agreed upon formula and the seller made an annual election to hold or sell the 10% stake
- Like seller financing and earnouts, rollover equity can 1) align incentives and 2) bridge valuation gaps
- Ensure you have experienced advisors on your team, as factors such as liquidity preference and preferred returns can wipe out the value of rollover equity
Transition Periods
Transitions are important. Every business we take to market includes a sentence along these lines:
Owner is amenable to providing the required training to a new owner to the extent that it is necessary based on their background; this can likely be achieved in 45 days. Beyond this initial transition period, should the buyer wish, owner is willing to be available as needed for advisory / consulting at an agreed upon hourly rate.
It is standard practice to include some transition period in a business sale. This initial transition period is unpaid. Depending on the type and size of business, a transition period is generally 30 – 60 days.
The transition period is negotiated between the parties as part of an LOI (Letter of Intent). We define the number of hours / week, duration, and include the phrase, “at a mutually agreed upon schedule”.
Beyond this transition period, some owners are open to working in the business longer as a consultant or advisor, provided they are compensated. We discuss preferences with a seller before taking their business to market, and ask them to help us populate this sentence:
Seller agrees to be available at a rate of $XXX / hour, up to YY hours / week, for ZZ months after a 45-day transition period.
Some of our sellers already have a second home and are eager to leave the dreary Pacific Northwest winter. Others have no plans to move / relocate and are open to staying as long as a buyer wishes. Every seller is different on their preferences, as is every buyer.
At minimum, buyers like to have an advisory / consulting agreement in place to know they can tap into the knowledge of the seller, as needed, in the future. It could be for 3 hours / quarter of strategic planning or we have seen a buyer wish to bring a seller to 2 or 3 important industry conferences to make introductions and set up key meetings.
Exec Summary – Deal Levers
Our goal with this series has been to open your eyes and demystify deal structure.
There are many levers beyond the transaction price. Tax treatment, seller financing, down payments, earnouts, rollover equity, and transition periods all play a role in getting fair deals done.
A seasoned M&A Advisor can help you negotiate, guide you through options, and ensure you are protected.
Hopefully, you are a little smarter on deal structure. As always, thank you for reading.
At Washington Business Brokers we are experts in valuation, optimizing a business for sale, buyer identification and qualification, negotiation, deal structuring, and closing.
If you would like to better understand the value of your business or learn more about the process of confidentially selling:
call or text 206.703.3555
email info@wabusinessbrokers.com
or schedule time for an exploratory, free consult
100% confidential, always.
When the time is right for you, we will be proud to partner and advise on your fair deal.
Want to learn more?
Start with our 2024 guide to selling your business or check out recent market data and multiples.
