If you are planning to sell your consulting firm, and our recent research with buyers of consulting firms tells us it’s a good time to do so, it is very likely that the transaction structure will contain an earn out.
It can make up a significant part of the consideration you receive for your firm so negotiation of it should be treated with care and respect. Earn outs come in all shapes and sizes and many sellers have fallen foul of some obvious (and not so obvious!) pitfalls over the years. It is imperative to structure any earn-out with reference to your specific circumstances; there are of course recurring themes and drawing on our deep experience of this complex area we explain below 10 of the most common considerations.
90% of deals involving consulting businesses will have a structure which includes some sort of deferred payment, with most taking the form of an earn-out. As identified in our Buyer Research, the average cash paid upfront accounts for only 46% of the total value, meaning earn outs can also make up a significant part of the consideration.
Earn-outs can be used by a buyer for any number of reasons but some of the most common are:
- to obtain commitment from the vendors post transaction
- to introduce specific targets which are non-financial to ensure a smooth transition post deal
- to mitigate a valuation based on the delivery of a high growth forecast
- to lower the day one funding requirement; and
- to bridge a gap in price expectations between vendor and buyer by allowing a higher headline value
10 Critical Success Factors
1. What should the earn-out target be?
Set it too high and it becomes a disincentive, too low and it won’t be incentive enough. The target should be achievable for the vendor and provide a mechanism which ensures good value, driving the right behaviours for the buyer.
2. Avoid complex, many-variable structures
Complexity of earn-out structure makes it very difficult to negotiate and document legally during the transaction, and also difficult to measure post transaction. The result is excess negotiation during the process and subsequent arguments post deal.
3. What happens if you leave?
Ensure you know what happens to the earn-out payments if you have to leave part way through, either through your own choice or a forced exit. There are many ways to ensure that you are protected in this case.
4. Consider the implications to the integration process
Earn-outs can sometimes be a hindrance to integration of the vendor’s business into the buyer as typically the vendor’s business needs to be ring-fenced from a reporting and operating standpoint in order for earn-out can be measured. This can destroy value for the buyer and also completely undermine the original rationale for undertaking the acquisition in the first place.
5. Earn-out payments rely on the financial viability of the buyer
Being satisfied that the buyer will still being solvent at the end of the earn-out period, or including protections in the sales documentation is key.
6. Set a realistic time period
The effluxion of time means that an earn-out is at risk from the vagaries of market conditions, customer losses, technology advancement, increased competition, etc. A two or three year period is typical – obviously the shorter the better for a vendor. Our recent research highlighted that while the average length of earn out was just less than three years, prolific buyers (those who bought more than 2 businesses per year) were more likely to prefer a shorter earn out period. Knowledge of buyers’ behaviour is invaluable in these negotiations.
7. Limit the basis of an earn-out to aspects of the business you can control post deal
For example, if your business is heavily reliant on marketing spend to achieve sales growth and post transaction you have no control of the marketing budget then immediately you are putting the achievement of your earn-out at increased and unnecessary risk. A full assessment of the transaction situation pre and post deal will highlight any areas of concern.
8. Corporate overheads
Be aware of any ‘costs’ which might be added to your P&L by a buyer post transaction and which could limit your chance to achieve your targets. Knowing how a buyer will behave post transaction and getting these issues on the table for discussion early is a key role for any advisor.
9. Tax treatment
With any performance based payment there is a risk that the tax authority in your jurisdiction will look to treat it as income rather than capital with the attendant increase in tax that comes with it. Get good tax advice early.
10. How should it be structured
All or nothing earn-outs don’t tend to work, so typically a sliding scale with caps and collars to penalise underperformance and reward over performance are the norm. A thorough understanding of whether the buyer’s aims are purely financial or whether they are mostly strategic has an impact here. Will it be possible to catch-up payments later? How is performance to be measured – quarterly, annually, on average?
Conclusion
Earn-outs can come in all shapes and sizes and the scope for getting it wrong is considerable, usually with significant consequences on what you expected to gain from the sale of your business. Understanding the motivations of a buyer and then formulating a structure which meets those expectations whilst protecting you as a vendor is the ideal scenario.
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