Earn-Outs and how they impact the sale of a business
By Matt Slappey CBI, BCI
Certified Business Intermediary; Mergers and Acquisitions (M&A) Advisor
Former GABB President Matt Slappey gave a presentation on earn-outs, what they are and how they can be used in the sale of a business. For those who missed this valuable presentation, the GABB gives you access to a recording of the speech and an outline of his PowerPoint presentation.
Definition according to Google:
A provision written into some financial transactions whereby the seller of a business will receive additional payments based on the future performance of the business sold
Wikipedia defines it as:
Earn out refers to a pricing structure in mergers and acquisitions where the sellers must “earn” part of the purchase price based on the performance of the business following the acquisition. In an earn out, part of the purchase price is paid after closing based on the target company achieving certain financial goals
Reality of an Earn-out
- An earn-out is used in most cases to bridge what a seller thinks his/her company is worth to the price that a buyer is putting on that same business.
- When a business is full of “potential” that the owner has never actually realized (some of this is real and some is smoke)
- Keeps negotiations alive when the parties seem far apart.
- You have a listing/engagement with a client.
- The client has $500K per year in cash flow.
- The market will tell you that a buyer’s offer of 3 x cash flow is not unreasonable.
- The seller wants $2,000,000+ or a 4x+ multiple
Things to understand
- Why does the seller think the company is worth more than the market rate?
- Is there a valid reason that the company is worth more?
- Is there true “unrealized potential”?
- Is the company about to land a large contract or opportunity?
Examples of Companies that lean towards an “earn out.”
- Consulting companies
- No sales reps other than the owner
- No management other than the owner
- Family members involved in the business
- Professional practices
- If you are going to seek financing via an SBA loan for your deal, do not pursue an earn-out because the SBA does not allow the use of earn-outs. They require a defined purchase price.
- This is not the SBA lenders in the room making the rule, it is the SBA.
- Create an earn-out that is the most simple and effective way to measure company or owner performance.
- Complicated earn-outs must be clearly understood by all parties and all parties must be able to verify all the information required to create the payouts
Types of Structures
- Revenue Goal
- Gross Profit Goal
- EBITDA or SDE Goal
- Retention of current clients
- Acquisition of new clients
- Most earn-outs are treated as an “Installment Payment” which allows taxation in the year it is actually received.
- Can use this technique to keep taxation of sales of smaller businesses under the top tax rates.
- It should also be noted that there may be situations in which a seller would choose to recognize the sale of a business currently and forego deferral treatment, such as when a business is sold at a loss, or when it is known or expected that tax rates will increase in the future.
Taking care of employees
It is possible for an owner to expense a portion of his earn out payments that are then paid to employees for retention or performance that leads to the seller receiving an earn-out payment. Scenarios change as to how to legally do this based on differences in an asset or stock deal, so consult a qualified attorney and/or tax advisor.
This can really motivate employees to achieve the earn out goals, thus earning it for the seller!
Earn outs are a powerful tool to bridge the gap in business values.
Both sides can benefit from using them effectively.
There are tax implications and advantages of earn outs.
Knowing how to navigate earn-outs can help you close more transactions.
Matt Slappey, 404-486-0350, firstname.lastname@example.org
Those who attended the August GABB meeting got to hear an excellent panel discussion of how brokers can reduce risk in a deal.
GABB President C. David Chambless moderated the panel of GABB Affiliates.
The panel included:
Dan Browning, JD, of DB Consulting, Inc., has 20 years of experience as a business appraisal professional and holds the Master Analyst in Financial Forensics (MAFF) and Accredited in Business Appraisal Review (ABAR) designations from the National Association of Certified Valuators and Analysts (NACVA).
David Cross, Senior Vice President-Wealth Management and Wealth Management Advisor with Merrill Lynch, is a specially qualified Portfolio Manager in the Merrill Lynch Person Investment Advisory® (PIA) Program, and can build and manage customized investment strategies and implement proprietary model portfolios, as well as provide traditional advice and guidance.
Larry Domenico, JD, is managing partner of Mozley, Finlayson & Loggins LLP, and practices extensively in the areas of products liability defense, commercial and business litigation, and general litigation; he has extensive experience in assisting start up and existing businesses, including estate planning for business owners, and alternate forms of dispute resolution including arbitration and mediation.
Chris Fonzi, founder and principal of Logic Environmental, Inc., has performed environmental assessments and provided consulting services in more than 20 states during the past 15 years. He is a graduate of the University of Florida and the UF School of Law.
Brian Harper is Senior Vice President, SBA Group at Atlantic Capital Bank and has 25 years of business banking and lending experience, and is a member of the Rotary Club of Dunwoody, Junior Achievement, Georgia Lender’s Quality Circle and the National Association of Government Guaranteed Lenders.
Sarah Wheeler, JD, a senior associate at Moore & Reese, primarily works with corporate transactions, community association law, real estate law (including foreclosures) and estate planning.
Guests are welcome to attend the GABB’s monthly meeting which starts 10:30 a.m. at the South Terraces Conference Center and is preceded at 9:45 a.m. by a free light breakfast and networking session. The GABB is the state’s largest professional organization dedicated to buying and selling businesses and franchises. The South Terraces Conference Center is at 115 Perimeter Center Place, Atlanta. For more information about the GABB, contact GABB President C. David Chambless at email@example.com or 404-627-4454.