The Earn-out
For the commercial lawyer, nothing is trickier than negotiating, closing, and following through on an “earn-out” sale of a business.
In larger transactions each side will obtain one or more business valuations and then haggle a price based on these, but in more modest transactions, the business owner usually asks for as much money as he thinks he needs to retire, and the purchaser wants to pay a fraction of that, with no money down, no payments for five years, and twenty years to pay off with no interest. An earn-out falls somewhere between, where the ultimate price will be determined by performance and paid out of ongoing profits.
The seller, of course, fears that the purchaser will turn out to be an idiot who will quickly run the business into the ground, walk away, and leave the vendor with a pile of cold ashes. The purchaser typically believes himself to be a genius who is going to trick this pony into levels of profitability of which the previous owner only dreamed, and that there will be enough surplus cash in the first year that he’ll go to the former owner and offer a large but discounted immediate cash payment.
The lawyer for the seller needs to remember two things. First, this sale is often the retirement nest egg of the founder who has worked hard for a lifetime to build the business and now just wants to move up to the lake and take it easy. And now that he’s decided to retire, he wants it so badly he can taste it, and he wants it all wrapped up in a hurry.
Second, you have to keep in mind that an earn-out, or any deal with future payments, is nothing more or less than a credit transaction. If you’re going to buy a car on credit, you can be sure the bank wants a full chattel mortgage over your car. If you don’t pay, they seize the car. The sale of a business should be no different.
There are all kinds of skilful ways to ensure that the seller retains the ability to take back the business, but of course that’s not of much use if the buyer simply took the thing for a joyride, crashed it, and walked away. So the first thing a seller, who is also a lender, needs to have is regular financial reporting with further rights to question and investigate if the numbers seem off.
Until the last payment is made, the seller needs to be able to grab the steering wheel if the buyer is letting the business run down. I often had a hard time selling that to the buyer’s lawyer, but if you put it this way, you usually get co-operation: “Listen, my guy wants your guy to succeed and make the business wildly profitable. As long as the buyer is doing that, nobody is going to trouble him. But if he starts doing things or ignoring things which spell trouble for the business, it’s not just in my client’s interest that he grab the steering wheel, it’s in your client’s interest, too. Take advantage of the deep experience and wisdom of my guy, and rest assured, he really will only come down from the lake if he thinks it’s really serious.”
If the business is corporate, it’s ideal for the vendor to retain a class of shares which give him priority voting rights in certain circumstances. A caution here, though, there could be tax implications in doing so, and this mechanism should not be put in place without tax advice.
Speaking of tax, of course, the vendor’s lawyer in structuring the deal needs to understand the tax results of any device. Getting security at the cost of paying tax on income as opposed to a capital gain is rarely a smart thing to do. This is why I rarely if ever ran a business sale without a good tax accountant at my elbow.
But not all of us sell our businesses, and not all of us advise on business sales. What all of us do, however, is buy on credit, and launch into all kinds of deals, including partnerships, marriages, and joint purchases (for example, of a condominium unit) where we are going to have to deal with “the other side” for years, if not a lifetime.
Whether a spouse, a condominium board, “the other side” has ideas and expectations which might sound like yours at the outset, but really are not the same as yours, and as time goes on, are more likely to diverge than converge. Knowing the deal you’re so eager to make is important for a lifetime, the more you can slow it down and get really good, insightful advice, and ensure that the “buyer” and the “seller” are truly on the same page, can make all the difference between a life of satisfaction and a life of regrets.