[author: Mark Ferris]
The owner of an Accounting business in California is in advanced discussions to sell her business to a New Jersey-based buyer.
Many terms are settled… but the parties have acknowledged that the business is ‘dependent on the Seller’. For example, she works directly with some large Clients and is responsible for most of the marketing and sales.
The Buyer wants to structure the deal as an earnout, which is unappealing to the Seller.
Earnouts are common deal structures when selling Accounting businesses, but they have drawbacks. Let’s look at this in more detail.
What is an earnout?
- An earnout means the Buyer pays for a business using the earnings from the business, usually with an initial down payment
- The amount due to the seller will usually decrease if earnings don’t meet expectations
Why structure a deal as an earnout?
- Selling an Accounting business involves risk, especially when clints (and maybe employees) won’t continue with the firm
- This risk is usually much higher where the business is highly dependent on the seller
- ‘Dependence’ might mean that clients or employees are highly loyal to the Seller and/or that the seller produces a lot of work and/or that the Seller manages important processes in the business
- An earnout reduces the Buyer’s risk and increases the Seller’s risk because payment to the Seller is linked to business performance (earnings) after the transaction
- In an earnout, therefore, the Buyers and Seller's goals and interests may not be fully aligned
What are some challenges with earnouts?
Applicants will probably consider several job offers and evaluate compensation in the short and long-terms.
Lost Client (and lost earnings)
- In an earnout, a Seller is highly motivated to retain Clients but a Buyer may be willing to ‘cherry pick’ the Clients they want to keep
- In fact, a Buyer may raise price or reduce service levels which encourages Clients to leave
- This negatively affects a Seller whose payment is linked to revenue and earnings
- Buyers who pay cash upfront tend to be more diligent about Client retention while earnouts result in a higher percentage of lost clients
Continued Participation by the Seller
- An earnout usually means the Seller stays on after a sale (because they feel more at risk)
- Generally, that’s the opposite of what a Seller wants… Which is to STOP working in the business
- The Seller’s continued involvement prolongs their influence and prevents the Buyer from taking charge (e.g. building strong Buyer-client relationships)
- Usually, the buyer pays the Seller a fee to stay on and provide transition assistance. Sometimes the Buyer may be willing to lose clients rather than continue paying this fee
Disputes
- Many sellers are used to working independently without restriction but the post-transaction environment can be challenging, leading to conflicts
- These conflicts arise because of different priorities, and are heightened when the seller receives less than they were expecting
- The calculations associated with earnouts can be complex… leading to misinterpretation or even manipulation by the parties
- Unfortunately, there is a relatively high incidence of conflicts arising from earnout deals
Nonpayment of Interest
- In most enormous earnouts, the Buyer pays no interest on the deferred payments, which is prejudicial to the seller
What are some ways to reduce seller risk?
- The best outcome is that the Seller and Buyer agree that post transaction risks are negligible and agree a cash (or cash equivalent) deal, with no earnout of contingencies. In this case, there will probably be zero dependence on the seller; difficult to achieve but entirely possible.
- Alternatively, increase the upfront portion (and limit the contingent portion) to reduce Seller risk
- Alternatively, make any deferred payments NOT contingent on client retention to reduce seller risk
- Alternatively, shorten the contingency period and adjust the percentage of price adjustment for each dollar of lost revenue to reduce seller risk.
Any other tips for a seller?
- A seller should define their priorities. What is REALLY important? The business valuations, payment terms, post transaction obligations, creating a legacy, something else?
- There may be a need to compromise… but a clear sense of the priorities helps secure the most important outcomes
- Remember, a cash deal also benefits the buyer, who can take control of the business quickly
- In many cases, earnouts are necessary to protect the buyer, especially where there is a risk of a seller competing with the firm or there is high dependence on a few large clients.
- All owners should set out to reduce dependence on themselves. In that case, earnouts become irrelevant.
How dependent is your business on the owner(s)? Or other team members?
Reducing dependence takes time and focus but carries considerable business benefits including avoiding earnouts when selling the business.
