The tricks and traps of earn-out clauses

How do you value a business when you are selling up? How do you find a buyer when the banks aren’t lending? The earn-out clause – which ties the seller to their business by holding back part of the sale proceeds until certain performance hurdles are met – is one answer, and is likely to become the norm over the next few years.

Done well, it can deliver bigger returns than the buyer had originally envisaged. But it’s fraught with danger for the selling entrepreneur.

The earn-out bridges the expectation gap between the buyer and seller. For example, you might base your sale price on a certain level of forecast earnings over the next few years, but in this market the seller is being cautious. The earn-out defers part of the total payment. The seller is paid the first tranche on the sale, often a sizeable sum to keep them in the game, and then, a further payment after an agreed period based on future business performance. The amount of the deferred consideration is based on agreed performance hurdles. It can run anywhere from a number of months to years and might include earn-out payments at different stages during the period.

In other words, the buyer minimises their risk by providing some financial incentive for the vendor to work hard in terms of the company’s business after they close the deal.

An earn-out makes it easier to sell the business, particularly those businesses that are difficult to value. And for the buyer, the earn-out offers the new owner protection against overpaying for a company that did thrive or grow in the way its original owners had expected. The deal can also smooth the period of ownership transition.

The earn-out clause in a contract usually extends the sale for two to three years. The minimum is one year or one audit cycle. The clause is generally based on the business achieving profit over a certain threshold for a set period of time. If the business meets the projections of the vendor over that time, the vendor gets paid a set amount. But if the profit growth exceeds that threshold, they get paid an increment. Potentially, that means the vendor could make much more money from the sale than the original price.

The profit growth thresholds and increments will vary from business to business, from industry to industry. In almost all earn out contracts, the vendor is given control over how profits are generated. Also, if the company is being absorbed into a larger entity, there has to be some reporting mechanism to show the profits of the acquired company, now the division of a big organisation. In terms of the tax treatment, the sale has to be treated as a capital gain rather than income.

Some entrepreneurs swear by earn-outs, saying they guarantee a sale for more than expected. Others say they are to be avoided because the hurdles keep shifting and the seller starts bringing in new clauses that were not there during the negotiations. They say that an up-front fee for everything is cleaner.

Done well, earn-outs can deliver win-win outcomes. But they have been known to breed distrust and disputes.

Robert Hurst, director of business brokers Hurst Partners, says earn outs are not as common here as they are in America but he predicts they will become more prominent because it is more difficult for buyers these days to raise money from banks.

“The banks have traditionally lent on goodwill, providing it’s backed up with real estate security,” Hurst says.

“But what we finding now is that the equity level isn’t anywhere near what it used to be. We are finding that with the price of housing and with people upgrading their property and taking out bigger loans, the equity doesn’t support the borrowing if they want to buy a business.”

He says he is now negotiating one earn-out where the buyer is just being extra cautious.

“He can fund it alright but chose not to because it’s the sort of business you can’t determine through the due diligence provisions that everything is kosher,” he says.

He says earn-outs can work well for buyers. “It’s a fairly smart way to do it because you know the seller is prepared to do it and has confidence in the business so there are no little nasties lurking in the background.”

What’s needed, he says, is an absolutely rock solid contract specifying what can and cannot happen.

“You need to have a very clear understanding in the contract of the conditions of the earn-out and what has to be done. You can’t have the purchaser once they get control of business changing the way things are done.”

But according to some entrepreneurs, that is exactly what happens. Serial entrepreneur Philip Weinman, who has sold seven fast-growing businesses including CTS Travel Hisoft and Vitamin Me, says two of his sales were earn-outs. He will never do it again.

“The problem is that they don’t allow you to run your race, the goal posts change,” Weinman says.

“What happens is you get hit with all these extra head office costs and they don’t allow certain things to go the way you did before.”

This can include the acquiring company, which is usually much larger, bringing in its HR department. Or suddenly the entrepreneur is told they can’t do profit share any more in Melbourne, because it would mean Melbourne staff get paid more than their counterparts in Sydney. Or the entrepreneur discovers a meal allowance has to be paid for those working after 6pm when before the acquisition, people did not work hours and instead just did the job. With new administrative systems, he has to pay more costs.

And the entrepreneur has to deal with reporting structures and pay structures that are now radically different.

“They take the entrepreneur’s flair and vision and they make it more administrative,” Weinman says.

“If you take that person out of the leadership role and put them into an infrastructure, what tends to happen is that the founders get upset and feel like their hands are tied and then they give up.”

“I have been taken over seven times and every time I get taken over, the intentions are great and they pay you a lot of money because they believe the culture will make a difference to their situation. Then what happens is that they start introducing different systems. The truth is that the founder does not go to these companies to get better systems. They are going there because they have a pay-out and because they want to stay in the business because it’s all about the people that are in there.”

He says his company Diesel Group, has one rule when it does a takeover. “Having been down that track so many times, we have learned that if you are going to acquire a company or merge with a company, you have to leave the founder alone,” he says.

Fred Schebesta from Hive Empire sold his company Freestyle to Q Limited in 2007. He says if he had to do it again, he would just take the cash.

He said in that takeover, Q Limited had acquired eight or nine companies. Freestyle was just part of the mix and, as Schebesta discovered, it was not given that high a priority. That was unexpected.

Did the goal posts shift?

“There are no goal posts, everything is negotiable,” Schebesta says.

“Next time I am in the same situation, I probably won’t look for an earn-out, they are too messy. There are lots of legal interpretations and unless there is a very good deal in taking an earn-out, I would take the cash up front.”

“They are pitching you their vision and you are telling them your vision, but in actual fact, they have other ideas.”

Other entrepreneurs say earn-outs achieve a great deal when the buyer and seller know how to work together and are coming from the same direction.

David Trewern more than doubled the size of his web development digital marketing business DT Systems when he sold it to STW Group over a period of time. The last 51% of the business was sold in a three year earn-out.

“I ended up getting a higher sale price than I expected,” Trewern says. “I probably ended up receiving twice as much for the equity that I sold than I anticipated three years earlier.”

The deal went well for several reasons. First, he was responsible for handling the merger. Secondly, the interests of the buyer and seller were aligned.

Trewern says anyone entering an earn-out needs to ensure that alignment. A contract would be no good without it.

“No contract can really compensate for being at loggerheads from the outset,” Trewern says. “If you are not on the same page and supporting each other, it’s not going to be productive for either party.”

“Unless you are working together to grow the business, then no earn-out agreement will help too much.”

And earn-outs are often the only alternative for entrepreneurs who can’t sell their companies that easily.

Travelcorp founder Helen Logas says earn-outs can work well. In October, she sold her Smart50 stalwart company to Brisbane-based travel giant Corporate Travel Management for an undisclosed price.

Logas did not want to talk about her earn-out specifically but said that in general, they work when the acquiring company cuts the seller some slack and allows them to continue running things.

“The advantage is that we have identical cultures and identical systems so the transition should be very smooth for our clients,” Logas says. “If you are lucky enough to make an acquisition where there are similar cultures and similar systems then that is highly advantageous.”

“There is no doubt about the fact that there have been horror stories about acquisitions at large, let alone people not being able to meet their earn-outs, but I think if the acquisition is performed in accordance with the seller and the seller is continuously kept in the loop and consulted about anything to do with their business, then that should make for a very good acquisition plus earn out. Otherwise what’s the point of doing an acquisition if your intention is to acquire and then rule the roost? It’s going to be damaging to any potential business that will come with the acquisition.”