In any transaction involving staffing companies, non-contingent consideration in the form of cash, stock and notes be used, with relatively straightforward terms. However, many deals include contingent consideration or “Earnouts.”
Earnouts are usually not a large part of the deal, yet they do offer the possibility of additional consideration to the seller, and can be the difference between a good deal and a great deal. For this reason, a seller should be aware of the rewards possible from a well-conceived earnout, while understanding all of the ramifications before entering into substantive negotiations with the buyer.
WHY HAVE AN EARNOUT?
The attractiveness of an earnout is different for the seller and the buyer.
For the seller, an earnout offers a way to maximize the total proceeds of the sale. Sellers who are confident about the growth potential of their business often consider accepting an earnout for a portion of the purchase price. This is especially true if the seller believes that the company’s rate of growth will be higher than what the buyer is projecting. The willingness of the seller to accept the risk of an earnout (in addition to substantial non-contingent consideration) demonstrates the seller’s belief in the future performance of the company.
If the earnout is properly structured and the company meets or exceeds its earnings goals during the earnout period, the total proceeds to the seller should easily surpass the amount of an all-cash price. Furthermore, taxes on the contingent payment(s) will not be due until after the payments are received, thus deferring a portion of the seller’s tax bill until a later date.
For the buyer, deferring a portion of the purchase price will serve a couple of purposes. First, the earnout should serve to motivate and incentivize the seller during the earnout period, with a successful earnout resulting in a win/win situation for both the buyer and seller. The buyer must understand that the higher the percentage of contingent consideration in the purchase price, the more the buyer should be willing to provide additional upside to the seller if the seller meets or beats the buyer’s expectations.
Secondly, by deferring a portion of the purchase price to the earnout, the buyer is able to use the acquired company’s income from operations during the earnout to help fund the earnout, thus enabling the buyer to pay a higher price for the business. Additionally, earnouts reduce the buyer’s risk (i.e., upfront purchase price) in the transaction, should the acquired company not perform as expected after the sale.
TYPES OF EARNOUTS
Earnout payments, although usually only a small component of the total deal, can be structured many different ways and for this reason, must be explicitly detailed in the purchase agreement. These payments are usually calculated either as a function of earnings before interest and taxes (EBIT), gross profits, revenues, or a combination thereof. Although we have seen literally dozens of different earnout structures, in our experience the majority of the earnouts fall into the following categories.
Multiple of EBIT Growth Earnout – The most common earnout methodology used in the temporary staffing and IT services industries is the Multiple of EBIT Growth approach. Since most deals in these industries are based on a multiple of EBIT, it makes sense that this popular earnout scenario is also based upon an EBIT multiple. Using this approach, the seller is rewarded for achieving earnings above a specified amount during the earnout period (we have seen earnouts of up to three years, although the current trend is towards shorter earnouts, usually no more than one year). The earnout threshold, or “Base”, is negotiated between the buyer and seller, with the Base usually equaling the acquired company’s earnings over the previous twelve-month period. Thus, the earnout will only have value if the acquired company’s earnings continue to grow. For example, if the company’s earnings over the previous twelve months (the “Base Year”) were $2,000,000, then the earnout calculation would apply only to the difference between the year one earnings and the Base Year earnings (called the “Earnings Growth”, which in this case would be any earnings in excess of $2,000,000). A pre-determined multiple would then be applied to the Earnings Growth to determine the amount of the earnout payment, with the multiple usually being slightly lower than that used to determine the upfront consideration. If the earnout includes a second year, then another pre-determined multiple is applied to the difference between the year one and year two earnings.
Gross Profit Earnout – Another earnout scenario we see is one based upon reaching certain gross profit projections during the earnout period. This type of earnout will be used when the acquired company’s operating expenses are not normative, or when the acquiring company anticipates integrating and managing the operating expenses of the combined businesses after the sale. The seller will usually receive an agreed upon amount for each gross profit dollar that exceeds budget. This approach sufficiently motivates the seller to continue seeking new high-margin business (new business will need to exceed a certain markup), yet frees the acquirer to make any reasonable and necessary operating expenditures or changes.
Grid Approach – The most complex earnouts are ones that involve an earnout grid. The grid consists of certain revenue, gross profit and earnings parameters, with the seller’s earnout determined by where on the grid the company’s performance falls during the earnout period. A dollar value or EBIT multiple will be placed in each sector of the grid, with successively larger rewards being possible for better performance. Of course, if the seller does not meet the minimum expectations of the buyer, then no earnout payment will be awarded.
WHAT TO CONSIDER BEFORE AGREEING TO AN EARNOUT
1.In examining the various earnout approaches, it should be obvious that for a seller to maximize their earnout potential, they must assume some risk in the transaction. The higher the non-contingent consideration that the seller receives, the more the seller will forego the upside potential if the company does well in the future.
2. An owner must also realize that their continued employment will be necessary through the entire length of the earnout. For this reason, the seller’s employment agreement should be compatible with the terms of the earnout. For owners planning to step aside immediately, an earnout will only work if they have strong succession management ready to take over the operations of the business going forward.
3. Additionally, the seller must have the authority to control the operations of the business throughout the earnout. The most frequent reason that earnouts fall apart is because of control issues after the sale. The seller’s legal counsel should insure that the seller retains sufficient control over all day-to-day operating decisions, as well as protections involving the business’ current client list and markets served. Meanwhile, the acquiring company should agree to not hinder or diminish the seller’s opportunity to maximize their earnout. For example, if the buyer opened a competing office nearby, the seller’s earnout could be negatively impacted. Ultimately, the purchase agreement should have language that clearly allows the seller to maintain control of expenses down to the line items on the income statement.
4. Another item to consider is how the selling owner will motivate the staff to maximize the company’s performance during the earnout period. Although certain members of the seller’s management team may receive stock options as part of the deal, ultimately it is up to the seller to take the additional steps necessary to incentivize the staff after the deal closes. Specifically, it is our experience that the most successful earnouts are ones where the owner allocates a portion of the earnout proceeds to the staff employees. We have seen some creative, tax efficient structures that accomplished this objective. This certainly is a motivator for the staff, and usually enhances the final proceeds to the owners.
5. Finally, the seller should consider the risk/reward tradeoff inherent to an earnout. If the owner does not plan to stay on with the business after the sale, does not have adequate succession management, is uncertain as to the future growth of the business, or simply does not find the earnout potential lucrative enough, then an earnout may not be the best option. However, if the seller believes strongly that the company will continue performing exceptionally in the near future (and the owner is motivated to stay and manage the business), then structuring a portion of the deal to include an earnout may be the best way to maximize the total purchase price of the company.
About De Bellas & Co.
De Bellas & Co, is the leading investment banking firm in merger and acquisition advisory services, exclusively for the staffing and workforce solutions industry, bringing over 30 years’ experience and over 230 transactions in this specialty. De Bellas & Co.’s success is driven by a commitment to serving as a strategic and financial advisor, to meet the long-term needs of its clients. Please visit debellas.com for more information.
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