Negotiate The Right Deal Terms When Buying A Business

Deal terms for buying a business have changed significantly due to the current market. Two specific components have been most affected. First, on the financing side, the lack of bank financing has lead to a significant increase in seller-financed deals. We have discussed this in prior posts however there is a second aspect of deal structures has been equally impacted because of the current market.

As you know, many businesses are experiencing revenue and profit declines. For a prospective buyer, this presents an instant “red flag”. If the business is down, how can one gain any comfort or assurance that the trend will be reversed? Of greater concern is whether the decline could get steeper. So what is a buyer to do?

Imagine that you find a business you like and it meets your overall criteria. However, sales and profits are declining, and the seller tells you it is temporary (typical story by the way). The basic fundamentals are sound, but you certainly cannot overlook the present state of the business. After all, the most recent past is a glimpse into the near-term future and you certainly do not want to buy a business that will continue to plunge the moment you become the new owner.

Additionally, what typically happens is that the seller has priced the business based upon past data when the business was doing well, and in their mind, the purchase price should reflect those prior levels. Of course, if the business today is at the same level, their asking price may be valid. But if the business is in decline and there is no valid evidence that it will soon be reversed, clearly, a buyer cannot pay for what it used to be.

So what is the best strategy?

Actually, it is easy; you must structure the deal based upon certain future events materializing. These are called “earnouts” and they provide for a buyer to pay a certain price if the business gets to certain levels, or if certain specific events are realized after you take over. In other words, an earnout is where the seller “earns” a specific amount of the purchase price based upon specific criteria materializing in the future. For example, it can be based upon achieving certain sales levels, or retention of specific clients/suppliers, or gross margins hitting certain levels, etc.

Now, you will find that sellers are usually apprehensive about this because the price is no longer guaranteed, but truly, it is the only structure that makes sense.

With earnouts, there are a few things to keep in mind:

• Avoid complicated earnout formulas. Ideally, you will want to identify the specific issue of concern to you and tie the earnout to it. For example, if sales are down 25 percent, the earnout can be based upon sales returning to the prior levels.

• The earnout period has to make sense for both sides. If the period post sale is too long, a buyer can effectively reward the seller for their hard work, instead of the original intent of paying the seller for what the business was when they sold it. Conversely, if the period is too short, the seller may balk at it being unrealistic.

• Have a mechanism to measure the earnout and also a vehicle to finalize it should there be a disagreement. For example, you may want to identify a neutral third-party accounting firm in advance that both sides agree to who, in the event of a dispute, can render a final decision.

• The earnout percentage has to make sense relative to the entire deal. Let’s say you have a business that you value at $1,000,000 but 50% of the profits are tied to one customer. You cannot simple say that the entire valuation is tied to that one client. Instead, you may want to offer a $1,00,000 price but half of it is based upon the business continuing to do the same volume with that client for at least 24 months after the purchase. In effect, the seller gets $500,000 as the purchase price and, they have the potential to “earn” the additional $500,000 if the client’s volume remains stable.

• Be reasonable and be prepared. The only way to get a seller to agree to an earnout is when you can logically explain the consequences of not having one in place. A buyer must be able to articulate their concerns and specifically address why the business is not worth what the seller believes based upon the specific area that warrants the earnout.

We are seeing a huge percentage of deals being done this way by our clients. In fact, it is something we are pushing for very aggressively on their behalf. After all, it is the only vehicle that a buyer has that can shift the risk in the deal to the seller and guarantee the future success of the business.

In this market, buyers hold the cards, so make sure you are adequately equipped with the knowledge and skills to negotiate these types of deal terms. They can, on their own, make the entire difference between the success  or failure of your deal. If you want to learn more about the personalized consulting we offer for business buyers click here.

Have a great week.

Comments

[Harry Hvostov]

Richard,

Earnout arrangements can be helped by analyzing business goodwill.

Strong reliance on a single customer may imply strong personal relationship between the seller and the client.

One way to determine the earnout amount:

Split the goodwill into personal and business institutional parts. Since the personal part may be harder to transfer to the buyer, hold it back in an earnout arrangement.

[Brad Yeager]

Richard,

Earnouts in my mind have previously been reserved for larger transactions, often when a PEG or industry buyer was involved. Are you seeing earnouts trickle down into lower mainstreet deals? We have seen a few in deals under a $1M asking price but not often. Is there a bottom asking price that you think earnouts make sense for?
In our experience the biggest factor in an earnout situation is TRUST. The changing economy is complicating business valuations and with limited funding available to buyers an earnout can be a great way for the seller to recognize what they believe to be a fair asking price with what the buyer believes to be a fair current market value. The foundation for an successful earnout is trust between buyer and seller. The seller has to believe in and trust that the buyer has the ability and resources to continue to run and improve the business and the buyer has to trust that the seller is accurately portraying the current status and opportunity of the business. For an Earnout to work all cards need to be on the table, doubt and skepticism will very quickly table an earnout discussion. When done right it can be a powerful mechanism to bridge the gap between buyer and seller in an uncertain economy.

The fear from the sellers point of view is 1. The buyer does not really have any incentive to obtain the earnout benchmarks if it is going to result in a significant payment due 2. How can the seller be sure the buyer is capable and competent to run the business successfully 3. What is a reasonable time period for the Earnout benchmarks to be achieved.

I would love to hear your thoughts and experiences on this.

Regards,

Brad Yeager

[george mistuloff]

good common sense article