Purchasing a Business Through Earnouts: An Optimal Strategy
In the realm of business transactions, earnouts have emerged as a popular method for balancing risk and aligning incentives between buyers and sellers. These performance-based conditions are designed to motivate sellers to maintain or grow the business post-sale, while ensuring that buyers are protected from potential losses.
Earnouts are usually linked to achieving specified financial or operational targets, such as revenue, EBITDA, cash flow, or client retention. These performance metrics serve as a powerful motivator for sellers to keep the business thriving after the sale.
One of the key aspects of structuring an earnout is risk allocation. The structure should balance risk, ensuring that neither party assumes an unfair burden. In a pure earnout, the seller assumes most risk, receiving payments only if targets are met, while the buyer pays nothing upfront or assumes less risk. However, this can lead to misaligned incentives, such as the buyer "cherry-picking" clients to boost short-term results.
Another crucial factor is the measurement of net working capital (NWC). For transactions where working capital affects earnout payments, it is important to establish a baseline NWC reflecting normal operating levels, accounting for seasonality and one-time events. The actual NWC at closing is then compared to this baseline, with true-ups post-closing to settle differences.
Key terms, including how targets are measured, baseline calculations, and timing, should be agreed upon early in the sale process (ideally in the Letter of Intent) to avoid disputes later. The transition and client retention strategy also play a significant role, as the buyer’s approach to client service and maintaining staff can impact the outcome.
Regarding the length of the measurement period, typical earnout periods range from 12 to 24 months post-closing. This timeframe balances allowing enough time to demonstrate performance against the business’s normal operating cycle and market conditions, while not dragging out seller payment excessively. Longer periods may capture seasonality and longer-term trends better but come with increased complexity and uncertainty.
Earnouts should be considered in scenarios such as customer concentration issues, recent significant growth, or business decline. A floor should be set for the earnout, so it is not paid if the metric is below a certain percentage. In situations where the business has experienced a recent downturn, a buyer may prefer a shorter measurement period. Conversely, if the seller has implemented initiatives that generate revenue after the sale, a longer measurement period may be necessary.
To structure an earnout, two valuations are needed: one based on status quo financials, and one based on the scenario where the measured event occurs. The delta between the two valuations becomes the earnout target. To address this, a seller can carve out a portion of the potential earnout that is subject to adjustment if the target is not met.
In most cases, the earnout measurement period is between 12-24 months after the deal is closed. Earnouts are most acceptable when there is a sliding scale in place, allowing for partial payment based on partial achievement. Earnouts, also known as performance-based conditions, can serve as a way to bridge the gap between buyers and sellers in business transactions.
Sellers cannot guarantee a buyer's success, and there is a risk that the buyer's incompetence could lead to a loss of customers. Earnouts provide the seller with the opportunity to earn the full valuation if certain future targets are met, and protect the buyer if those targets are not met. The seller must assume part of the risk if they deliver a business that is likely to change significantly in the near future.
In conclusion, earnouts offer a flexible and effective way to balance risk and incentives in business sales. By setting clear, measurable targets, agreeing on baseline conditions, and structuring a fair risk-sharing arrangement, both parties can benefit from a successful post-sale period.
- To ensure a successful post-sale period, one may consider purchasing a business with an earnout structure, which serves as a performance-based condition linked to achieving financial or operational targets, such as revenue or client retention.
- In structuring an earnout, it's essential to allocate risk fairly, agree on key terms early in the sale process, and establish clear measurement periods to avoid disputes and ensure that the business is thriving even after finance has been exchanged.
