mergers banking & acquisitions
BUSINESS BUILDERS
Earnouts: Manage your A seller’s cash flow primer in a Lindsey few Day simple by steps by Craig Veurink
TIPS 1.
Set a realistic goal for when you want to break even. This will help you to focus your efforts and TIPS provide a numerical benchmark for projecting your cash flow in the 1. In near some future cases, an earnout is used 2. ifPut thecash buyer flow and before sellerprofits. are unable It to might agree seem upon counterintuitive, a valuation of but the target if you aren’t and thus organizing a fixed your purchase cash price. flow, you’ll run into problems that 2. Earnouts a profitablecome quarter with might risk,not be particularly able to fix to sellers, including 3. post-closing Secure creditdisputes ahead ofcentering time. Most around small business the metrics owners driving should the earnout secure aspayment. much credit as possible. 3. Financial-based This is the best way milestones to be prepared are more for thecommon unexpected than performance4. based Consider milestones, using a payroll with revenue, service. net Having income the professionals and EBITDA take beingcare most of collecting widely payroll used. taxes saves 4. Earnouts them an enormous should beamount of limited of time, helps streamline their cash flow duration, with current trends 5. running Schedulethree youryears payments. or less.Don’t The go delinquent but do divide the your longer the earnout period, payments greater theinto risk.categories such as “must pay,” “important to pay” and 5. It’s vital to have a mechanism in place “flexible forpayment resolvingterms.” disputes Thisthat can arise help keep between sufficient parties. cash on hand.
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Earnouts, a form of contingent payment payable upon completion of a post-closing financial and/or performance-based milestone, are a relatively common feature in business transactions and their usage is becoming more widespread. The circumstances under which earnouts are utilized vary from transaction-to-transaction. In some cases, an earnout is used to bridge a valuation gap; for example, if the buyer and seller are unable to agree upon a valuation of the target and thus a fixed purchase price. This may be the case if the target Small businesses are usually is operating a new business line, and founded by entrepreneurs who have a a historical basis for the valuation is unique vision and a passion that drives lacking, or if economic trends and them to work late hours, take chances market conditions are particularly and believe in what they’re doing. But, uncertain, and buyers are being just as Thomas Edison once said that conservative in offering prices. genius is 1 percent inspiration and 99 Additionally, earnouts may be used if percent perspiration, successfully runan employee or group of employees is ning a small business requires rolling crucial for the target’s success. up your sleeves and putting in signifiIn the SRS Acquiom 2023 M&A study cant time on more mundane, day-toof deal terms, the financial transaction day matters. manager analyzed more than 400 You can be driven, impassioned and private-target M&A transactions that have a great idea to fill a niche or serve closed in 2022 and found that 21 percent customers in new ways, but if you (excluding life sciences transactions) don’t attend to the details of the busicontained an earnout. In 85 percent of ness, you can create for yourself a heap the transactions, the earnout period was of problems. three years or less. Here, we’ll look at one of the most Earnouts are not without risk, important of these business details: particularly to sellers. One such risk is managing cash flow. Especially for post-closing disputes between buyer early startups, knowing how much and seller, which often center around cash is coming in and going out, the calculation of the metric(s) driving and accurately forecasting sales and the earnout payment. Furthermore, expenses, is key to maintaining your following closing, buyer and seller company’s health. are still relatively unfamiliar with the No matter where you are in your other’s management style. A seller may business, keep these things top of thus be skeptical as to how its business mind: will be managed by buyer after closing, including whether it will be managed in 1. Know when you will break a way that might reduce the likelihood of even the earnout being achieved. Every small business owner keeps at With all of this in mind, how might the front of their mind the question: a seller approach the negotiation of an
UPSIZE NOVEMBER • DECEMBER 2023 2022
earnout? Matters for sellers to consider include:
• Type and reasonableness of
milestones. Financial-based milestones are more common than performance-based milestones. Of the different types of financialbased milestones, revenue, net income and EBITDA are the most widely used.
While net income links the earnout to profitability, it poses greater risks to a seller because the buyer is more easily able to control and/or “When do I start to turn a profit?” manipulate the treatment of interest, Rather than wonder, set a realistic goal taxes, depreciation and amortization for when you want to break even. This in its calculations. For that reason, will help you to focus your efforts and sellers frequently prefer EBITDA provide a numerical benchmark for milestones. Whatever milestone(s) is projecting your cash flow in the near utilized, it should not be so aggressive future. as to be entirely unachievable. Buyers may be overly ambitious in proposing 2. Put cash-flow management milestones to reduce the likelihood of before profits them being attained. This might seem counterintuitive, since profits are how you survive. • Length and termination of However, if you aren’t organizing your earnout. An earnout should be of cash flow, you’ll run into problems limited duration. As noted, current that a profitable quarter might not be trends reflect earnout periods of able to fix. Keep things organized and three years or less. Generally, the well managed so you can be ready for longer the earnout period, the whatever success comes your way. greater the risks. There are metrics other than time, however, such as 3. Secure credit ahead of time the occurrence of a specific event, Too often, small business owners an option by buyer, and/or a sale of wait until they need it to secure credit. the target, that may trigger and/or This can cause a lot of unnecessary terminate an earnout. stress, or worse. Talk to experienced business owners in your area and Of these metrics, the ability of buyer industry ahead of time to know how to terminate an earnout in exchange for much revenue you’ll need up front. a predetermined payment is generally Take a realistic look at the situation least preferred by sellers because such and plan. You might have sufficient payment is generally lower than what cash reserves or a rich uncle who is might otherwise be achievable. only a call away, but most small business owners should secure as much • Accounting matters. Seller credit as possible. This is the best way should ensure that the same to be prepared for the unexpected. accounting treatment (i.e., www.upsizemag.com
