I Have to Keep Working for How Long!

Imagine you’ve spent the last 20 years building a great business with your business partner and management team.

And now it looks like you’re on the way to achieving a great business exit. A couple of months ago you signed a letter of intent with a listed public company and negotiations have been going well. They are impressed with your business growth story and have agreed to pay a generous multiple for your business.

However, your last meeting with the buyer and their advisers was unsettling — lots of talk about revenue and profit targets, performance earn-outs and instalment payments.

Most of it went straight over your head so after the meeting you pulled your business adviser aside for an explanation. “It’s all standard stuff when dealing with a listed company”, he explained. “I’ll walk you through it tomorrow after they’ve sent across the details”.

There are four “out of left field issues” that can derail a business exit. A performance earn-out is left field issue #1. It can also be an insidious one as it just creeps up on you during your business exit.

If your business exit ends up including a performance earn out it will have a major impact on how your exit unfolds and a big impact on you personally.

Here’s how the “standard stuff” actually plays out in practice.

“We love your business”

Early in my career, when working as a corporate lawyer, I did a lot of work for a large listed public company in the communications industry. They were ambitious, fast growing and acquisitive. Over only a few years they purchased and successfully integrated dozens of smaller businesses into their organization.

I worked closely with their CFO, let’s call him Peter. He was personable, sharp as a tack and a consummate deal maker.

Rather than trying to talk business owners down on the aspirational prices they wanted for their businesses, Peter would spend time getting an understanding of why they thought their business was worth so much. As owners talked up their businesses, Peter would quietly and subtly “educate” them about how his company viewed value, performance and reward.

At this point, the business owner would finally concede that their current financials didn’t support the inflated sale price they were looking for — but their future prospects would.

At this point, Peter would deliver his negotiating master stroke: “We love your business and really want to pay you what you believe its worth with the opportunities and prospects you have in the pipeline. In fact, I want to structure your deal so you have every opportunity of achieving just that.”

Peter would let this sink in and then continue with, “So, we’ll pay you most of what we think your business is worth upfront, and then put in place a performance earn-out arrangement. You stay on with the business after we buy it, and if it delivers the results you’re confident it can we’ll pay you for the extra proven value. Obviously, we’ll also pay you a good industry-based salary package while you’re with us.”

By this stage, any business owner keen to do a deal found themselves in an impossible position. They couldn’t complain they weren’t getting offered full value, and — having talked their business up — it was hard to backtrack without looking foolish.

In practice, Peter’s company rarely paid out performance earn-outs in full as few businesses they bought ever achieved their earn-out targets, even those that performed well. From my experience this is a common outcome.

Why performance earn-outs favor buyers

Essentially, a performance earn-out means the price a buyer pays for a business is determined by its profitability over a period of time, during which the business owner — and often key members of their management team — continue to work in it. Also, the purchase price is paid in instalments over that period, subject to earn-out targets being met.

In practice, performance earn-outs tend to favor the buyer as:

  • the buyer can pay the sale price in instalments over time rather than upfront
  • it reduces the buyer’s risk, as they get to see how the business really performs before they fully pay for it
  • it locks in the business owner and often key members of their team for a period of time to ensure the full benefit of the business is transferred to the buyer

On the other hand, they can be fraught with danger for sellers. In particular:

  • the business owner is often hindered from achieving the same level of profitability once the business is operating in a larger corporate environment
  • many business owners struggle to continue operating the business well when they’re no longer calling all the shots
  • a lot of business owners lose their drive and enthusiasm for their business once they no longer own it

In summary, while performance earn-outs can work for sellers, from my experience they need to be very carefully considered and structured.

For an initial discussion on how best to prepare for your business exit, contact us here for a 20 minute complimentary consultation.

Geoff Green is a well‑known business exit strategist, entrepreneur and corporate lawyer. He is also the author of The Smart Business Exit, Getting Rewarded for your Blood, Sweat and Tears.