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When working through a business sale, an inordinate number of resources on both sides of the table are dedicated to drafting and negotiating the Stock Purchase or Asset Purchase Agreement. This is true especially in the last one-to-two weeks before the closing. In fact, I’ve had clients remark that during their entire tenure as an entrepreneur, they never spent as much time speaking to their advisors as they did during the last week of their business ownership journey!
While I don’t dispute that it’s wise to seek professional advice when negotiating these important agreements, I also believe as much care should be dedicated to the initial confidentiality agreement between the negotiating parties and to the terms and conditions of any earn out agreement. Unfortunately, shortcuts with these two important business sale agreements are common.
The Confidentiality Agreement in a Business Sale is the First, Critical Document
It is very common for a business owner to be approached by a competitor about buying their business. Often such initial conversations are very friendly in nature. Accordingly, the business owner may find himself unprepared and feeling a bit awkward about the situation. Not knowing what to reveal or hold back places most business owners at a disadvantage early on in the selling process.
It’s also not unusual for a business owner to tell me they’ve already given a potential buyer a copy of their financial statements before they’ve sought professional advice and assistance. And while this situation is not ideal, it’s not too late to execute a confidentiality agreement with the potential buyer.
Confidentiality Agreements should be mutual as any potential business buyer should be willing to share their financial information with the business owner and his or her advisors. The business owner has the right, and his or her advisors have the obligation, to vet the financial ability of any potential buyer to purchase the business.
The confidentiality agreement should also spell out other obligations of the parties including, but not limited to:
- Maintaining the confidentiality of all information, reports, contracts, intellectual property, sales and financial information, tangible and intangible property, research findings, trade secrets, etc. as disclosed by the parties to the transaction.
- Using the confidential information only for the purpose of evaluating the potential acquisition.
- Prohibiting the buyer and the seller from making disclosures to others regarding the fact that a business transaction was contemplated should the transaction not occur.
To protect a business owner from a potential buyer ‘hiring away’ one or more of his key employees, I always recommend including an ‘employee non-solicitation’ clause in the confidentiality agreement for a reasonable period of time. This clause protects the seller and is very comforting when a potential buyer is a competitor. The last thing a buyer wants to face is a competitor picking off his valuable employees after the competitor decides to pass on the acquisition!
By starting the relationship with a well-drafted confidentiality agreement, the business owner is able to set the proper tone for the process and reduce risk if the acquisition doesn’t close. A credible potential buyer will understand its importance.
The Earn Out Agreement and Formula
Recently, I met a prospective client who asked me “one of my friends had an earn out agreement when he sold his business. Isn’t that risky and why would anyone accept it?”
Yes, earn out provisions have a bad reputation. But in fact, if properly designed and used, they can be valuable to the business seller and buyer alike. Let’s explore what they are, why they are used, and how to reduce the risk associated with an earn out agreement.
Earn Out Agreement vs. Business Owner Financing
An earn out agreement is not a form of business acquisition financing although it is often mistaken as owner financing or as a business owner ‘holding the paper’ for a buyer. In reality, an earn out agreement offers a means for a business owner and business buyer to bridge the difference between their respective opinions regarding the fair market value of the business.
Business owner financing is used in smaller transactions when the buyer is unable on his or her own merit to obtain the cash or financing necessary to cover the agreed upon purchase price. If a buyer proposes to a business owner to buy his or her business using an ‘earn out payment’, without a corresponding interest factor, the buyer should be shown the door.
Earn Out Agreements When Business Growth is Strong
When a business for sale finds it’s in a good business growth cycle, it’s natural for the business owner to want to capture that upside in the negotiated sale price. To a certain extent, this is possible. However, most business buyers are not going to give credit for future business growth (revenue or income) without hedging their bet. What if the future income doesn’t occur? Such ‘what if’ scenarios are appropriately addressed in an earn out provision in the business purchase agreement. If the future growth in business revenue and profit becomes a reality post acquisition, then both the former and new business owner can share in the incremental increase in the value of the business.
How To Align the Earnout Agreement So Everyone Wins
Aligning the post-acquisition goals for the business buyer to the earnout agreement offers both parties in the sale of a business an opportunity to achieve the best outcome. There are a number of recommendations for the business seller and the new owner to consider when drafting the earnout provision in the purchase agreements. They include:
- If the former business owner remains in the business as either an employee or a consultant for a period of time, he or she may have some influence over the business’ continued growth abilities and income. If not, then an earnout provision payment for the former owner may be a bit of a gamble. For this reason, earn outs are not usually recommended if the former business owner plans to end his or her employment after the sale closes.
- An earnout agreement is typically proposed by the buyer when there is a gap between the offer and asking price of the business. It may be based on a difference in opinion regarding the value of the business’ intellectual capital, other assets, and/or future income, among other factors.
Using the difference in opinions between the parties is often a good place to start when defining which factors should be the basis for the additional payments to the business seller.
For example, if the seller provides a buyer with a three year projection that indicates sales will increase at an annual rate of 15%, then this may be a valid benchmark for determining whether a seller will receive an earnout payment.
It is extremely important for sellers to carefully consider how their projections are prepared when they are requested by prospective buyers. If a seller believes his or her business is worth a certain sum with a three year projected revenue growth of 15% and the asking price is met by the buyer, then the seller must be prepared to meet or exceed that growth benchmark post acquisition. On the other hand, if a buyer doesn’t believe a projected growth rate is valid and proposes an earnout provision, you can be certain the buyer will propose using the seller’s projected growth rate in the earn out agreement.
- Earnout payments may be based for anything agreed upon between the seller and buyer. Having said that, it’s important to include trusted advisors and key employees when developing the earnout formula. Often it’s the CFO or COO who understands the inner workings of the business’ cash flow and profitability. In other words, be careful to not delegate the earnout formula development to those who don’t intimately know your business.
Once the earn out formula has been drafted, insist that your CFO and the Buyer’s advisor build out spreadsheet with several examples and include those as an addendum to the purchase agreement. Doing so will allow for the discovery of matters where more clarity is needed before the acquisition closes.
Once the business sale is a few years behind both parties, the earnout agreement may be regarded ultimately as one of the most powerful tools to offer the new business owner a successful transition and the seller additional compensation for his or her many years of hard work.
I am considering putting an offer in on a business that the owner has been negative cash flow for 2 years. About 5 years ago he became an absentee owner and hired way too many people to manage in his abscence. Revenues only declined slightly and marginal profit is still good but bottom line profits are now negative. I can cut the salaried staff in half and and replace a couple with very competent people I know and instantly return profitability.
Given the negative cash flow, I want to offer only an earn out of 50% net cash flow as long as I lease the real estate from him and I retain the right to buy the property.
Do you think this deal has a chance? The guy is living in Europe and wants to stay there full time. The way I see it, he can either let the business continue to spiral downward and shut the doors or let me and my team of professionals fix the business and get a slice of the pie.
Would any other buyer touch it with negative cash flows? I would appreciate your opinion on this.
Business acquisitions, such as what you’ve described, are possible. The key is being certain to align your objectives (positive cash flow) with earn-out agreement terms which are acceptable and fair to the seller. I recommend creating a number of ‘what-if scenarios’ to determine if your earn out agreement terms would work they way you and the seller intends.
As for other buyers, the answer is yes–other buyers may be interested in this business. It’s not uncommon for businesses to be sold when there is negative cash flow. The value of the business to a new owner is dependent in many ways on what the new owner will do (change, improve, etc.) after the acquisition is closed.
I am in the process of structuring an earn-out on one of my deals. We are calculating the earn out on a percentage of gross revenue.
Example of Earn Out Formula:
If a business sells for $3,000,000 dollars and the gross sales were $6,000,000, the purchase price of the business is 50% of gross revenue.
Now, if the business increases sales 10% post closing, the earn out might be 25% of the portion of the increase because the seller and the buyer worked together to increase the revenue.
In this example, a 10% increase (or $600,000 more revenue) would result in a $150,000 additional earn out payment for the seller. I believe this is the best way to structure the deal because it’s cleaner.
Good morning Ron,
Thank you for sharing your earn out formula with us. I agree, your earnout payment formula to the seller is very clean and should be simple to measure and track.
When using gross sales as the benchmark for an earn out payment, you should be careful to specify exactly what ‘gross sales’ means. For example, is gross sales measured by booked sales orders, or shipped sales orders, or collected revenue on sales orders.
All the best…
Holly, This is great advice on both topics – the importance of a confidentiality agreement and the importance of a close review of the earn-out agreement to determine where further clarity may be required.
While middle market companies may be able to successfully structure a strategic sale to customers, suppliers or competitors, that’s much more difficult and risky for main street businesses. There is so much written about the upside of strategic sales, it becomes important to explain the downside to main street businesses of disclosing information to customers, suppliers or competitors. On the How to Plan and Sell a Business website, we have an article which addresses this issue titled: “Customers, Suppliers and Competitors as Buyer Prospects” – http://howtoplanandsellabusiness.com/how-to-sell-a-business-newsletters/customers-suppliers-and-competitors-as-buyer-prospects/.