I’m not a fan of earnouts when a business is sold. An earnout is where the seller will defer part of the proceeds from their business based on certain sales or other goals being hit by the buyer. If the buyer doesn’t achieve the milestones that are agreed upon in advance, the seller doesn’t receive the promised money.
I’ve come to believe that earnouts could be considered a bonus for the sale to the seller, but that’s the only way it should be looked at. I believe that you can only count the money you get upfront as the real money that you get when it comes time to sell your business.
Some reasons that I think earnouts don’t make sense are:
The buyer is using your cash to pay for your business.
When you allow an earnout to be part of the purchase price for your business you are allowing the owner to use the cash flow your business produces to pay you for your business. If you’re going to do this, you might just as well keep the business and enjoy the cash flow for yourself.
You have transfered risk in the transaction from the buyer to the seller.
In an earnout situation the risk for whether the transaction works has been transferred from the buyer to the seller. You as a seller will no longer have any authority of how the business is run, but if it’s run poorly, you’re the one who will be taking the risk. It makes no sense to me that a seller would want to continue taking on the risk of running their business once they sell it.
Many earnouts don’t have any interest factors added to the purchase price.
If you’re allowing an earnout as part of the purchase price you might not be factoring the time value of money otherwise known as interest into the purchase price. If you are factoring an interest cost in, it often is too low for the risk that you’re taking.
If you’re going to “hold paper” in your transaction you should think of yourself as a mezzanine financer. This means you should get a higher interest factor than the primary lender and that premium should be quite a bit. After all, your loan is subordinate to the primary lender and you need to be paid for that risk.
In my opinion, earnouts are not worth very much in most instances. I believe you would be better off making necessary changes in your business so a buyer would be willing to pay you in cash for your business if and when you want to sell.
Making the necessary changes so you could sell your business for cash not only get more buyers interested down the road, but force you to make your business which benefits you today.
I would love to have a conversation with you about this article. Please either email me at Jpatrick@stage2planning.com or click on this link to set a time for us to have a personal conversation.
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