A purchase and sale agreement starts with a blank page – it can be as simple or as complicated as a buyer and seller wish to agree to.
So, when you’re putting together a deal to sell your business, it's really about creating a win-win situation. You want to get the best value for your business that you can while also allowing the purchaser to make a reasonable return on his or her investment – including factoring in the level of risk the buyer will perceive he or she will be taking on in the future of your business.
One of the risks that is sure to be top of mind for a potential acquirer is how well the business will operate without you, the founder and entrepreneur, at the helm. To help mitigate that risk, the buyer may want to negotiate an “earn-out” as part of the deal.
An earn-out is a variable portion of the negotiated purchase price that will be paid out in the future, over, say, three to five years, once certain target criteria are met. The amount of an earn-out is often used to bridge a valuation gap – between what the entrepreneur wants and what the buyer is comfortable committing to in cash at closing.
An earn-out is also used as an incentive to keep founders, owners or key management personnel continuing to work in the business for a set transition period; they only get all the money if the business performs in a specified fashion (say, by hitting profit projections or other set criteria).
“Earn-outs are a way for a buyer to shift the risk back on to the shoulders of the entrepreneur,” says John Warrillow, former Report on Small Business columnist, founder of the Sellability Score and the author of Built to Sell: Creating a Business That Can Thrive Without You .
“If you're going to sign up for an earn-out, make sure you're fairly compensated for your business up front in cash, because an earn-out is really just a bonus for a job well done. You're no longer an entrepreneur during an earn-out; you’re an employee, and that carries both benefits and risks.”
I have seen the downside risks of an earn-out in several acquisitions over the years. Despite the best of intentions, many business buyers took over the allocation of resources and steering the business after the sale. As a result, the entrepreneurs who sold their businesses felt they lost control and had many restrictions placed on them that effectively prevented them from meeting the goals set for their earn-outs.
Since buyers are trying to transfer risk to sellers when they request an earn-out, I’d advise any entrepreneur to do as Mr. Warrillow suggests: Make sure to get a cash price that really is a satisfactory selling price, and consider any earn-out as a bonus.
Furthermore, I’d suggest a seller work closely with a buyer on the structure of the earn-out, including specifying performance expectations, resources that will be made available, the level of autonomy that will be granted, and each party’s obligation. That way, a seller will be in more of a position to realistically hit the targets to gain that earn-out.
Under ideal conditions, an earn-out suits both parties well. However, this is business, and conditions are rarely ideal. Be fair to yourself and to your buyer when agreeing to an earn-out.
Special to The Globe and Mail
Chris Griffiths is the Toronto-based director of fine tune consulting, a boutique management consulting practice. Over the past 20 years, he has started or acquired and exited seven businesses.
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