Selling your business – the case for effective earnouts

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Any business sale and purchase, regardless of the amount involved, seems to raise the same questions: How much should be paid for goodwill, and will the purchaser receive the full benefit of that goodwill?

In practice, particularly with larger deals, goodwill is often calculated as a multiple of EBIT (earnings before interest and tax). In non-technical terms, EBIT is basically the profit made by the business in an average year assuming the business has no debt and no tax.

If the EBIT is $1 million in an industry where businesses are normally sold at 3 times EBIT, then the goodwill will be $3 million. In some businesses the multiple is one times EBIT and in others it can be far higher, depending on the industry.

Often the purchaser of a business pays dearly for goodwill, only to find that the business is unprofitable. Why? It’s often hard to know whether the business wasn’t profitable in the first place, has fallen on hard times (for example because of economic downturns or price wars with competitors) or has been mismanaged by its new owner.

Once the vendor has walked away with the sale price of the business, the risk is on the purchaser. Even if the purchaser has carried out due diligence, the new business can be a Pandora’s box full of unpleasant surprises. More astute purchasers involve their lawyers heavily in the due diligence process. In one of the business purchases that we have dealt with, a client carried out its own due diligence and was dismayed to find out, far too late, that the vendor did not have any of the major agencies it claimed to have.

Another of our clients bought a business, encouraged by the vendor’s verbal assurances that the business would achieve a certain level of sales. Not surprisingly, its actual turnover turned out to be a huge disappointment. The purchaser may be able to sue the vendor for misrepresentation, or for deceptive or misleading conduct under the Fair Trading Act. Legal action however can be expensive, stressful and an unwelcome distraction from the newly acquired business. Some purchasers are more fortunate, because the vendor has provided some finance.

A purchaser finding that the business is not the goldmine he was led to believe, might refuse to pay part of the vendor’s finance. This can be legally fraught, as technically the purchaser has no right of setoff and should pay all the vendor finance, then sue the vendor afterwards (with all the difficulties that entails). Generally the risk is entirely on the purchaser. Some purchasers however link the amount that they pay for goodwill to the profits earned after taking over the business, sometimes called an “earnout”. This is more common when the vendor is employed to manage the business even after selling to the new owner.

Under an earnout arrangement, most of the purchase price is paid on settlement, but some is paid by a series of instalments for two to three years after settlement. If the company’s profits are less than anticipated, the amount paid for goodwill is reduced by a formula. The agreement should be structured carefully so that instalments paid after settlement, even though they are linked to the company’s profit, are payments for goodwill. As long as they are payments for goodwill they will be tax free in the hands of the vendor, even if they are linked to the company’s profit.

An earnout can change the balance of power. The vendor is losing control of the business and, if profits fall for any reason after settlement, the goodwill payment might be reduced considerably. Most vendors are prepared to take this risk only if they are receiving a relatively generous amount of goodwill. No vendor would want to sell a business for a low amount of goodwill, then receive even less because of an earnout arrangement. Any vendor’s finance should be secured. Most purchasers are not able to give security over property, but generally they can give a general security agreement over the company’s assets. (This is not always good security particularly if the purchaser has to give prior security to a bank). In many cases personal guarantees should be required as well. Any earnout arrangement needs to allow for a range of possibilities:

• What if the purchaser resells the business? • What if the business restructures, or merges with another business? • What if the purchaser goes into receivership or liquidation? (There is probably little that the vendor can do in this case except rely on any security that it has been given.) • If the vendor is now working for the purchaser, what happens to the goodwill payment if his employment is terminated? • Can the purchaser manipulate the EBIT, for example by employing far more staff, running down the business or arranging for associates to charge management fees?

Where the vendor is asked to stay on as manager or chief executive officer there always seems to be a clash of cultures eventually. It is very difficult for a vendor who has been in charge of a business for some years, to run that business with full accountability to new owners. They almost always have divergent plans for the business. The vendor tends to be focused more on the company’s profitability over the earnout period, rather than long term issues, but we have seen cases where the vendor takes a longer term view of the business than the new owners. Some earnout arrangements seem to be a game of Russian Roulette, placing far more risk on the vendor. We recommend that only small parts of the goodwill, if any, should be linked to the profitability of the business after settlement. Any agreement involving earnout arrangements should be prepared and put into place with great care. Experienced legal advice should be taken at every point.

mm
Les Allen
Partner

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