An Update on Earnouts

New accounting rules may require that acquirers and acquiring companies report earnout agreements as liabilities.

Joel Johnson, president of Orchard Partners Inc., in his article, “Earnouts,” published by Valuation Strategies, states: "In a given year, 2% - 3% of announced mergers and acquisition agreements involve earnouts. These figures probably understate their prevalence. Earnouts tend to be a characteristic of smaller deals; and in many small deals, terms are not announced. Earnouts are rare when public companies are acquired and more common when ownership is concentrated among a few shareholders."

This would mean, if implemented, that earnout agreements must have a value placed on them for accounting purposes. As Joel Johnson points out, “The higher the earnout, the greater the liability.”

Why the Earnout?

Johnson further states that earnouts are used for various reasons:

1. to bridge the pricing gap between the seller who places a heavy emphasis on the company's projections, and the buyer who places most of the company's value on its present and past performance.
2. to tie the acquisition payout to future performance.
3. to create a form of seller financing in that some of the buyer's purchase price is delayed into the future. 4. to establish a form of escrow account in that the money is paid on condition of meeting certain thresholds.
5. to act as a type of employment agreement in that the CEO has to stick around in order to collect.

Remember: It Is Not Always the Price

The following are situations where the price was not the deciding issue in the successful sell of a business. The ultimate buyer may be the only one who really understands the situation. A business intermediary really understands the issues and can lead the buyer and seller to a successful resolution.

• One seller had 60 shareholders who needed to walk away from the deal. The losing buyer wanted all selling shareholders to be accountable for the "reps and warranties." The winning buyer waived the reps and warranties at closing.

• A seller's management team wanted some future upside in the deal. The losing buyer offered all cash and normal compensation. The winning buyer offered 80% cash, 20% stock plus 3-year earnout on revenues -- including acquisitions.

• Time was of the essence. The losing buyer needed 30 day due diligence and negotiations plus a 60-day window to close the deal. The winning buyer offered to close within 40 days of the Letter of Intent and agreed to have limited due diligence.

The Three Ways to Negotiate

Basically, there are three major negotiation methods.

1. Take it or leave it. A buyer makes an offer or a seller makes a counter-offer – both sides can let the “chips fall where they may.”

2. Split the difference. The buyer and seller, one or the other, or both, decide to split the difference between what the buyer is willing to offer and what the seller is willing to accept. A real oversimplification, but often used.

3. This for that. Both buyer and seller have to find out what is important to each. So many of these important areas are non-monetary and involve personal things such as allowing the owner’s son to continue employment with the firm. The buyer may want to move the business.

There is an old adage that advises, “Never negotiate your own deal!”

The first thing both sides have to decide on is who will represent them. Will they have their attorney, their intermediary or will they go it alone? Intermediaries are a good choice for a seller. They have done it before, are good advocates for their side and they understand the company and the seller.

How do the parties get together in a win-win negotiation? The first step is for both sides to work with their advisors to settle on the price and deal structure positions. Both sides should be able to present their side of these issues. Which is more important – price or terms, or non-monetary items?

Information is vital to a buyer. Buyers should keep in mind that the seller knows more about the business than he or she does. Both buyer and seller need to anticipate what is important to the other and keep that in mind when discussing the deal. Buyer and seller should do due diligence on each other. Both buyer and seller must be able to walk away from a deal that is just not going to work.

Bob Woolf, the famous sports agent said in his book, Friendly Persuasion: My Life as a Negotiator, “I never think of negotiating against anyone. I work with people to come to an agreement. Deals are put together.”

Considerations When Selling...Or Buying

Important questions to ask when looking at a business...or preparing to have your business looked at by prospective buyers.

• What’s for sale? What’s not for sale? Does it include real estate? Are some of the machines leased instead of owned?

• What assets are not earning money? Perhaps these assets should be sold off.

• What is proprietary? Formulations, patents, software, etc.?

• What is their competitive advantage? A certain niche, superior marketing or better manufacturing.

• What is the barrier of entry? Capital, low labor, tight relationships.

• What about employment agreements/non-competes? Has the seller failed to secure these agreements from key employees?

• How does one grow the business? Maybe it can’t be grown.

• How much working capital does one need to run the business?

• What is the depth of management and how dependent is the business on the owner/manager?

• How is the financial reporting undertaken and recorded and how does management adjust the business accordingly?

Reasons to Sell / Reasons to Acquire

A January 2004 survey conducted by the DAK Group/Rutgers found the following breakdown of why businesses are for sale:

Reasons To Sell

Risk reduction 44%
Competition or market changes 41%
External pressures 27%
Lifestyle factors (age, health, etc.) 14%
Lack of capital 9%
Ownership/management issues 07%
Note: Multiple responses allowed; Source: DAK Group/Rutgers

It is interesting to note that the top, by far, three reasons to sell are financial as is the fifth reason. The information furnished by much of the media suggests that the big reason to sell is generational – in other words, all of yesterday’s owners are now ready to retire. According to the survey above, that motivation (included in “Lifestyle factors”) represents only 14 percent, and it includes health and other personal issues. The last reason, at 7 percent, might also include retirement since ownership/management could be involved with retirement issues. Twenty-one percent of the respondents mentioned either lifestyle or ownership/management issues. Placing these reasons at the top of the list does not justify the hype of the “baby-boomers” retiring over the next few years.

Shown, below, the reasons for considering an acquisition seem to be more obvious. Although growth leads the list by a hefty margin, all of the other reasons could also be considered growth issues.

Reasons for Considering an Acquisition

Growth 72%
Acquire competitor 38%
Product diversification 37%
Geographic diversification 29%
Technology 09%
Note: Multiple responses allowed; Source: DAK Group/Rutger

Tips for Buyers

Don't be greedy.

Sellers deserve a fair price for the years they have spent developing their business. Be prepared to pay for the goodwill of the business.

Have a good reason to be buying.

Buying a business is hard work! It takes a commitment! Spend time deciding why you want the responsibility of owning a business.

Be prepared.

Be prepared with a resume and financial statement. Remember, the seller will most likely be your banker and will want to know that you can run the business successfully.

Keep an open mind.

There are no perfect businesses.

Don't forget the tax benefits.

Remember tax benefits are realized from intangible as well as tangible assets.

Offer a reasonable down payment.

A low down payment indicates a lack of commitment. When sellers question commitment, serious negotiations are in jeopardy.

Businesses are priced on cash flow.

A business making huge profits with few assets could save you money later in capital outlay for expansion.

Time is of the essence.

After all parties have agreed upon price and terms, it is important to quickly proceed toward closing.

Meet the landlord.

Landlords usually have little to gain by cooperation. Therefore, come to meetings armed with resume and financial statement.

Full disclosure.

Disclose pertinent information early and avoid surprises that might destroy your credibility.

Keys to a Successful Closing

The closing is the formal transfer of a business. It usually also represents the successful culmination of many months of hard work, extensive negotiations, lots of give and take, and ultimately a satisfactory meeting of the minds. The document governing the closing is the Purchase and Sale Agreement. It generally covers the following:

• A description of the transaction – Is it a stock or asset sale?

• Terms of the agreement – This covers the price and terms and how it is to be paid. It should also include the status of any management that will remain with the business.

• Representations and Warranties – These are usually negotiated after the Letter of Intent is agreed upon. Both buyer and seller want protection from any misrepresentations. The warranties provide assurances that everything is as represented.

• Conditions and Covenants – These include non-competes and agreements to do or not to do certain things.

There are four key steps that must be undertaken before the sale of a business can close:

1. The seller must show satisfactory evidence that he or she has the legal right to act on behalf of the selling company and the legal authority to sell the business.

2. The buyer’s representatives must have completed the due diligence process, and claims and representations made by the seller must have been substantiated.

3. The necessary financing must have been secured, and the proper paperwork and appropriate liens must be in place so funds can be released.

4. All representations and warranties must be in place, with remedies made available to the buyer in case of seller’s breech.

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What Should You Look For When Considering a Business to Purchase?

Unfortunately, too many prospective buyers want to know the asking price first, and then they ask how much money can they make. These are the wrong questions to ask initially. Buyers need to know how much cash the seller requires as a down payment. There is no point in looking at a business, no matter how good the numbers are, if the seller wants three times as much cash as you are willing to invest.

Remember, the actual amount of money a business earns is usually much more than just the bottom line. A smart approach is to get more information on the business, and even make a visit, before ruling it out or getting too involved in the numbers. It's all part of the learning process.