Negotiating a purchase price for a business is more complicated than haggling for a new car. Most business sales have at least some portion of the price paid after closing. This raises two questions for the seller—How much am I owed, and can I collect it? We see several common mistakes that business owners make when answering these questions.
Using Earn Outs Incorrectly
An “earn out” is a pricing structure where some or all of the purchase price is contingent upon the business hitting certain performance goals after closing. A properly used earn out typically overcomes two roadblocks to reaching an agreement on purchase price. Many disagreements over purchase price arise from disagreement over probability of certain outcomes. For example, a seller may assert that the business is worth 10 million dollars because it will sell 50 widgets next year. Buyer may say the business is worth only 8 million because it does believe the business will sell 50 widgets. An earn out can bridge this gap by making the 2 million dollar difference in purchase price contingent on the business selling 50 widgets.
An earn out may also allow the seller to capture value from the acumen or resources of the acquirer. If a target company has struggled because of lack of capital, market presence or other factors, acquisition by a larger company may increase profitability. A earn out may allow a seller to capture this upside by providing an additional upside contingent on the business hitting performance metrics that exceed past performance.
There are a number of risks associated with an earn out for a seller. It is often difficult to track whether a business has met its performance goals, particularly when the target business is integrated into an existing operating business. “Creative accounting,” in particular, overhead allocation, can make it appear as if a business is not performing or hitting its marks. Detailed provisions addressing the purchaser’s accounting practices help to reduce risk but such provision are fertile for disagreement and post-closing litigation.
Not Knowing Your Purchaser
If you are “taking back paper” – slang for accepting a promissory note in the place of a cash at closing – in a transaction, you are acting as a bank for your purchaser. Just like a bank, a well-advised seller should conduct due diligence on the potential buyer to evaluate its ability to make good on its promise to pay. This includes reviewing the purchaser’s financial statements, cash flow, other debts and ability to obtain money from other sources. A more generalized inquiry into the purchaser’s business track record is also important. How long has the purchaser been in business? Has the purchaser ever declared bankruptcy or does it have judgment against it? Is the purchaser highly leveraged?
Not Acting Like A Bank
A bank does not lend money without the borrower putting up collateral to back up its promise to pay; you shouldn’t either. The prudent seller treats the buyer as a bank would. Without adequate collateral, a seller may have a successful lawsuit against a judgment-proof entity or individual.
Of course, not all collateral is created equal. Clients who want to get the price they negotiated for their businesses like to see letters of credit, mortgages on real property and personal guarantees from the owners (and their spouses) of corporate buyers. Relying solely unsecured promissory notes from recently formed entities or a security interest in the assets of the business just sold is a recipe for disaster.
No transaction is without risk but thoughtful negotiation and good advice can help to minimize the chances of turning a happy time into a sore subject.