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I was at a Chartered Accountant Business Valuation Specialisation group meeting the other week and we were talking about earn outs and the presenter used a useful phrase that “earn ours are the price of owner dependency”.

What are earn outs

As business and practice brokers, we often see earn outs in services businesses, where the selling owner may receive additional consideration for the sale of the business based on the performance of the business after it has been sold.  The common performance criteria may include any or all of profits, revenue growth, staff retention, supplier retention and customer retention.

Services business commonly use earn outs as purchasers are concerned at the level of personal goodwill the business compared to create goodwill.  Personal goodwill is where the business’ ability to generate profits is highly dependent on the skills and effort of the owner.  Examples of high personal goodwill businesses include; a sole consultant, a single practitioner professional services firm or a brain surgeon.

Corporate goodwill is less dependent on the skills and effort of an individual.  Examples may include highly systemised businesses such as McDonalds, high brand recognition business (Coca Cola) or multi partner professional services firms.

Earn outs may also be required if there is a reliance on a few major customers or suppliers.

The concept of earn outs has merit in that the owner will get paid additional amounts if the business performs after the sale and the purchaser is will to pay additional amounts based on clarity of certain objectives.

The downside of earn outs

The challenge with earn outs is their implementation as there are potential downsides for both the seller and buyer with earn outs.

As a seller if your additional payments are dependent on the performance of the business after the sale, you will want to have the authority to manage the business as you see fit.  However these short term objectives may be in conflict with the objective of the purchaser.  The new business owner may have acquired the business for reasons which may include incorporating it into their business, to increase research and development and to invest in distribution capacity.  The vendor and purchaser may be in conflict on the level and allocation of expenditure on issues such as recruitment, training, systems development and marketing as well as the allocation of corporate costs.

After the sale, if the business underperforms for reasons outside the control of the founder, the founder may be demotivated – to the detriment of the seller and the buyer.

The founder is also taking a financial risk on the ability and willingness of the purchaser to pay the money due on earn outs.  There have been a number of bad examples of listed companies undertaking rollups of services firms using earn outs and/or escrow shares, only for the listed entity to go into administration before any earn out was paid or shares released from escrow.

Avoiding earn outs by reducing personal goodwill and increasing corporate goodwill

The primary reason that purchaser requires an earn out is their view of the uncertainty in how the business will operate after the sale.

In order to reduce or eliminate earn outs, the seller needs to be able to demonstrate that the business is not dependent on the exiting parties.  The evidence of this may include systems and processes depth and quality of staff, branding, defined market niches, lead generation system and an obvious successor.

Also having a good spread of suppliers and customers reduces the risk to the buyer of one supplier or customers failing to come across to the new owner.

An added benefit of reducing owner dependency is that by reducing risk, the purchase price of the business should also be higher.

We recommend that a business focus on being exit ready and take succession planning actions early to reduce or eliminate the key issues of owner dependency well before they decide to sell the business.

 

Peter Wallace

Endeavour Capital

Sydney & Melbourne

 

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