Bridging Valuation Gaps with Earnout Agreements
Nothing is more frustrating than when a motivated Seller and a sincerely interested Buyer fail to move on a transaction solely because of a valuation gap. The Buyer usually believes the “high” price is based on overly optimistic financial projections while the Seller feels the Buyer isn’t sufficiently recognizing the potential already built into the operation as a result of the Seller’s past efforts.
An “Earnout Agreement” can help bridge the gap when a Buyer and Seller disagree about the Seller’s business prospects. This tool can be especially useful when handling unknowns. For instance: a fairly new company; a company emerging from a difficult financial situation; or a company just starting to take advantage of a new investment, operational efficiency, or marketing strategy. Basically, Earnouts offer a way for the parties to bridge the expectation gap.
In a typical Earnout, the Buyer provides an up front payment to the Seller and then makes monthly or quarterly payments to the Seller based upon pre-established benchmarks. When meeting or exceeding these benchmarks, the Seller receives a higher price for the business; falling short results in a lower final sales price. There are advantages for both parties. The Buyer can initiate a transaction with a modest amount of cash and can mitigate the risk of paying too much for the company. The Seller can use the Earnout to negotiate a better asking price and then focus on helping the company work to achieve the promised results.
Successful Earnout Agreements must be tightly written with clearly defined benchmarks and responsibilities. Gross sales provide the ideal benchmark as it is more difficult to manipulate then net sales. The ideal time period for the Earnout requires finding the proper balance – long enough to avoid the temptation for the Seller to falsely accelerate earnings and short enough to let the Seller reap their rewards before the Buyer’s influence begins to dominate the operation. Typically this time period is between one and three years.
A well structured Earnout should also be backed by a contingent Promissory Note and collateralized with the business. It should also feature periodic monitoring to help keep the agreement on track and minimize potential for later disputes. A quarterly “audit” or review by an agreed-to third party accountant can help reassure both parties that the financial operations of the company remain on the up and up. Finally, Earnouts often include a dispute-resolution mechanism, such as arbitration as a means to solve problems quickly without the expense and time of litigation.
So keep in mind, if you are a Buyer or Seller, close to a making a deal on price but still too far apart to reach agreement, consider bridging the valuation gap with a Earnout Agreement.
For more information about buying and selling businessnes, and to view businesses for sale, visit our official website at www.vrdelval.com. To contact Brad directly email him at belliott@buyandsellbusinessblog.com.
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Brad Elliott is Principal/Broker at VR Business Brokers in Ewing, NJ. Brad himself has owned, operated, and sold a multitude of small to mid-sized businesses over the last 15 years. Brad received his MBA from MIT’s Sloan School of Management and comes from a family of entrepreneurs.
