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On Earnouts
Selling a company is a lengthy process and involves varying potential categories of buyers.
- Lighting OEM - strategic buyer
- Investment firm - investment buyer
- Family - a family appointment, an inheritance or designee to take over the company
- ESOP - employee stock ownership plan
Each buyer category has a role in defining the valuation of that transfer. In a simple purchase process, the buyer states their purchase price and the seller accepts or negotiates or walks away.
But buying a business is more complex than selling your old car; the valuation is often determined by a formal audit of the financials (which is quite costly and time consuming), or is determined after a review of significant financials from the seller (typically, at a minimum: 3 years of income statements, balance sheets, and a review of key customers, their channel(s) to the market and a physical review of the operations and extensive due diligence to ensure all financial, legal and operational records were accurate.
Most deals offer a percentage of cash and a percentage of deferred compensation (which could be calculated after a confirmation of actual assets). Many buyers prefer to demand a payment of the purchase price over time; i.e. a deferred payment schedule or a structured earnout. Paying later saves the buyer from spending current cash resources and obviously includes paying with non-inflationary dollars in the future. All offers are subject to negotiations, so the timing of the payout can be less than a year or several years. But buyouts can also be pegged to the performance of the company under the new owner. This is an ‘earnout’.
Earnouts are commonplace in offers from investment firms (Private equity). My challenge with earnouts is that the seller is getting the remainder of the offer based on the ability of the PE firm to manage their new acquisition. With a rash of failed PE investments in Lighting, I strongly advise my clients to negotiate an earnout based exclusively on timing and not performance. In short, I recommend a non-contingent deferred payment; with a payment date of no more than 1 year from closing. I also discourage owner-financing; whereby the buyer offers cash, plus a ‘loan’ from the owner to cover the balance of valuation payment to the owner. These ‘loans’ can run for over a year or more and are often pegged to the performance of the new company under new ownership. I strongly advise my clients to reject a loan payout, for the same reasons. Will they default on the loan if the business sours?
I am empathetic to the buyers; as they can’t know how well the company is run until they’re in charge of the operation, but those concerns should be mollified in the due diligence process.
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