You’re a business owner, and you’re ready to start chasing your grandchildren for travel ball, honors band, or to walk the Freedom Trail in Boston. Time to sell. If you’re thinking about selling a business in Nevada, there’s a number you should run before you call anyone.
Take whatever you’re currently running through the business that has nothing to do with running the business.
The payment on one of the “company cars” that doesn’t have a logo on the side and will never carry a product or a technician to a service call. The wages and health coverage for a grandchild who hasn’t been home since the summer after her first year at UC San Diego. The annual hunt club lease that you have taken clients on, but only the ones you like, and honestly, you’d take them whether they were your clients or not. Life’s too short, and you’ve worked too hard, to spend a morning in a duck blind with someone you don’t like.
Add it all up. Call it $100,000 a year in personal expenses you can reasonably run through the business as perquisites (perqs, or perks, if you prefer plain English). For the sake of this example, let’s say your federal rate runs around thirty percent, maybe a little higher, and for our readers with businesses in California, plenty of you live on this side of the line but do real business over there; you can tack on another eight or nine points of state tax on top of that.
We’ll stick with about $30,000 a year in tax savings, which is closer to what a Nevada business owner keeps, since there’s no state income tax up here to worry about. Over five years, that’s $150,000 in real tax savings. That’s absolutely real money, and it’s a good strategy as long as you and your tax professional are comfortable with it.
But how about when you’re ready to sell?
Again, for the sake of this example, let’s assume a multiple of three times EBITDA. Three times is a solid, defensible multiple for a Main Street business, and it’s likely conservative for something in the lower middle market. We’ll stick with three times here because we’re doing math in public.
Every dollar of add-back the buyer’s team can’t fully verify gets discounted, and at a three-times multiple, that $100,000 a year of personal expense isn’t worth $100,000 to you at closing. It’s worth $300,000.
You saved $150,000 in taxes over five years by running that $100,000 a year through the business. But if you can’t defend it at the table, you may leave $300,000 of purchase price on the table in a single afternoon, because the buyer (and his advisors and his lenders) can’t verify any of it as genuinely discretionary.
Was your granddaughter actually contributing to the business remotely, linking disparate systems with her expensive new computer science and AI skills? Or will they discover that nobody, including you, ever actually tracked her hours closely enough to defend them, the same way you’ve never tracked your own?
Most sellers haven’t run a time-and-motion study on their own days either. They know, the way you know things about your own life without ever measuring them, that they could probably spend less time in the business and it would run just fine. They don’t know how to stop showing up, and whether the business genuinely needs them personally is an open question nobody answers until somebody actually tries.
Will that big customer keep ordering at the same pace once the invitations to smoke cigars in the duck blind stop coming, or will he finally take your competitor up on that pheasant hunting trip to South Dakota?
The real fix was cleaning it up five years ago, the first time you felt a little sad checking in for your flight home after taking your kids and grandkids on vacation. You should have paid the tax and let your real earnings get verified by your own tax returns instead of your word for it (or don’t).
This is a big part of why larger companies, and public ones, sell for higher multiples in the first place: their sale price gets measured against audited EBITDA or revenue straight off the return, not a recast nobody outside the building has ever seen.
You probably won’t do that either, or didn’t. You’ll keep running the payment on that car with no logo, the fuel for it, and the hunt club dues through the business right up until the day you list, then hand a buyer a recast and ask him to trust it.
He won’t (and probably shouldn’t), and not because he thinks you’re lying to him. He just can’t justify an additional $300,000 of purchase price on your say-so, and neither can his lender.
That gap, between what you’re claiming and what he can actually prove, is one (very common) example of why there are earnouts.
If you can’t prove it, you’re going to have to earn it.
There are several valid reasons for a buyer to structure a deal with an earnout: A buyer might be nervous about a customer that’s forty percent of revenue and might not renew. While he likes the growth number from the last twelve months, he isn’t ready to pay for it as if it’s permanent. He might not have the cash to close without deferring part of the price to future earnings.
Regardless of the reason, the points below apply to earnout structures and will serve to level the playing field.
Last month’s column covered the basics, but here’s the short version if you missed it or want it refreshed. An earnout is a piece of the purchase price that doesn’t show up at closing. It shows up later, and only if the business hits a number both sides agreed to going in.
Buyers propose them because they can’t just take a seller’s word for what the business is worth, especially a seller who’s spent years minimizing what shows up on paper for tax purposes. An earnout is the buyer’s way of saying, “Prove it.”
Sellers accept them because the headline number looks a lot better with the earnout attached than without it, and (unfortunately) by the time most sellers understand what they actually signed up for, they’re already living under the agreement. That’s what this series of columns is trying to help you avoid.
And now to the poor soul we mentioned last month, who signed an earnout deal at the end of 2019. No one, save maybe a few PhDs in China, had any idea a global pandemic should have been on anyone’s bingo card. He closed on December 31. His earnout period opened January 1, 2020.
He did not hit his earnout numbers, and it wasn’t because he did anything wrong.
I think it’s fair to note that, while we’ve only looked at this from the seller’s perspective, the buyer took a serious hit too (though it was already addressed by boilerplate language buried in his loan agreement with his lender).
He paid a significant amount for a business based on a reasonable expectation that it would keep performing the way it had for years, and then all hell broke loose. His lender’s sophistication and experience ensured that his lending agreement had language addressing cases like this (they handle dozens of transactions every year). The seller’s earnout won’t unless his counsel has been beaten up by circumstance a little as well.
For both of them, the world just kind of fell apart, and it truly was no one’s fault (except, perhaps, for those PhDs in China). Even in these cases, with genuine victims of circumstance, there are ways to soften the impact to both sides if the agreement is drafted to account for it. We’ll get to that.
This month is about what to do before you’re that guy. How to structure an earnout so you actually get paid, and how to recognize when the smarter move is to walk away from one entirely.
The Metrics Are the Whole Negotiation
The majority of earnouts are built on a number the business has to hit. That number is either revenue, gross profit, EBITDA, or SDE, and the measure chosen is arguably the most important factor here.
Revenue is clean and easy. It’s hard to argue. Gross profit is close behind, since it’s revenue minus cost of goods sold. There’s less room to negotiate what something costs (of course, you can absolutely construct a scenario that throws gross profit into question, maybe decisions about how labor gets costed and accounted for, but the factors contributing to cost are still limited, and we’re assuming good faith on the part of both buyer and seller).
Regardless, both are much harder to manipulate through normal operations. Not impossible. Just harder.
EBITDA and SDE are different. Both are calculated after expenses, and expenses are easily (and frequently) impacted by a new owner in normal decision-making. He brings in his own bookkeeper. He renegotiates a vendor contract (maybe it goes up, maybe it goes down, but it changes). He might add a manager you didn’t have, because his wife isn’t willing to work the counter the way your spouse was, and no brother-in-law is willing to step in either.
A new owner is entitled to make these decisions because they own the business now.
However, if your earnout is measured on EBITDA (or SDE) and the purchase agreement doesn’t define, in writing, exactly which expense categories count and which don’t, you’ve ceded control of how to keep score because you didn’t define the rules.
That doesn’t make the buyer, or the buyer’s bookkeeper, crooked. It just means normal ownership decisions can move your number against you, with no ill intent from anyone.
What follows are examples, not a checklist to hand your attorney and consider the job done. They’re the kind of specific mechanics a good one will be focused on: reporting cadence, audit rights, defined categories of consent.
The exact terms below aren’t the only right answer, and they may not even be the best ones for your deal. The point of naming them is so you recognize why this part of the agreement matters and don’t let vague language slide by unchallenged.
A schedule that spells out, specifically, which add-backs remain and which new expenses are excluded from the calculation of EBITDA or SDE for purposes of the seller’s target, and who audits the number and how often, is the kind of thing that gets negotiated before the deal closes.
It is tedious and very specific work. Quarterly reporting with a defined dispute process beats an annual reconciliation and a phone call. If you can’t get that kind of specificity from the other side before you sign, that’s information. It tells you something about how the next two or three years are going to go.
There may be good reasons to use EBITDA or SDE as the payout metric anyway. But the price of doing it right is a lot of tedious work completed up front, before the deal is finalized, not after.
Closely related to expenses is control (obviously, we were talking about control over expenses as they relate to SDE and EBITDA). But control touches every aspect of the business you used to run alone.
If your earnout depends on hitting a number, what decisions actually move that number? Hiring for sales support? Marketing spend? Marketing spend, where?
If the new owner unilaterally cuts the marketing budget, raises prices to the point where some price-sensitive customers walk, or lays off a couple of employees who were sustaining an exceptionally high service level (was that service level higher than it needed to be for the price you were charging? That question might be heresy to a founder who pictures his own face in every client interaction. Still, it’s one every buyer has to ask, since he needs to make a living, grow the business, and service the debt he took on to buy it), and your earnout is measured against whatever metric those decisions affect, you’ve got the makings of real conflict and hard feelings.
This doesn’t mean running the business yourself during the earnout. It’s not your job anymore, and it wasn’t going to happen anyway. The buyer bought your business. It’s theirs now. They’d be fools not to ask for your input and opinions, but they paid for the right to make it grow, or run it into the ground.
What it does mean is getting the agreement to specify, in advance, which categories of decision require your input or consent while your comp depends on it. All that negotiation needs to happen before the deal is finalized, because it’s not going to happen after.
(Note that there are cases where sellers are specifically engaged to stay on and run things their way, backed by the resources a well-capitalized buyer can bring that they never had access to alone. That happens too, and it’s a generally better problem to have. It’s also the subject of another column.)
None of this means that an earnout is a good idea or a bad one. It means there’s a lot more to structuring one so everyone feels fairly treated (or, for our cynics, treated equally unfairly) than most people assume going in.
When the World Moves the Goalposts
Earnout agreements are frequently weak or silent about disasters that could kill the whole company, let alone just keep the seller from hitting his bonus. They assume, not unreasonably, that the business will run in a manner similar to the way it has historically for the length of the earnout.
But nobody would have named “pandemic” in 2019 any more than anyone outside the characters portrayed in The Big Short could have called the 2008 mortgage crisis before it crushed the economy.
It’s impossible to name all the things that could derail a market or an economy, so some agreements skip naming things entirely and define the trigger by its effect instead (example: a drop in revenue caused by forces and policies outside the company).
There will still be negotiations about how the company could or should have responded, but it wasn’t simply left as an open question to be negotiated solely after the fact.
I will continue to make lawyer jokes, mostly because they were better students than I was, but none of the specific language above should come from you (I assure you that it won’t come from me).
That leaves your transaction attorney and, yes, a cost to you. It’s worth it. Ask him directly whether there’s a reasonable middle ground between a three-word “acts of God” clause and trying to list every possible thing that could go wrong. There usually is. Find out where it sits for your deal.
When the Answer Is No
I’ve spent most of this column trying to be even-handed, getting both buyers and sellers to see the deal from the other side and assuming good faith throughout. That’s a reasonable way to approach a transaction, and life for that matter.
Unfortunately, there are still buyers out there who are going to try to get over on a less sophisticated seller.
Demanding an EBITDA-based metric while refusing to ever define an expense schedule, often with the excuse that it’s too complex or impossible to finish before closing, is one red flag.
Refusing to negotiate the control you need over the decisions that actually move your metric is another (and one that cuts both ways, since it also means you need to be able to name those decisions specifically enough to ask for them in the first place).
Either one, or worse both, means it’s time to take care of yourself. Be ready to walk away, or put a different structure on the table.
John Warrillow, of Built to Sell, counsels sellers to negotiate a deal where the cash at closing alone is satisfying and to treat any earnout as a bonus on top of that.
He’s interviewed hundreds of business owners after their exits, so the opinion carries real weight, and his books and podcast are worth the time of any business owner for whom a sale is a viable exit.
For that approach to work, though, you need a genuinely accurate sense of what your business is worth. Otherwise you have no way of knowing whether the cash on the table is actually satisfying, or just looks that way next to a bigger number with strings attached.
One fundamental characteristic of life, markets, and economics is that there’s no such thing as a solution, only tradeoffs.
If you want a larger, overall number, you’re likely going to trade your time and effort to get there. If you want to be done, not counting the typical training and transition period that comes with almost every sale, you’ll negotiate a smaller price up front.
An earnout isn’t an enemy. It’s a tool, and like most tools, it works fine in the hands of someone using it correctly and can cause real damage in the hands of someone who isn’t.
Whether you’re on the giving or receiving end of one, understand the tool before you pick it up.
Do the math on your own books as described in the first few paragraphs, ideally long before you’re ready to list your business for sale (we’d be happy to help you with that, that’s as close to an Altar Call as I will ever get in one of these columns).
Regardless of how you do it and who you engage to help you, try to do it with enough time that you can make the adjustments to minimize your personal expense add-backs (yes, this means possibly increasing your tax bill), or document your discretionary expenses so you can tie them to specific expense codes on your income statements.
It’s not as compelling as using a multiple of earnings reported on your taxes, but it’s better than guessing at discretionary expenses, adding them back, and hoping for the best.
When you get an offer with an earnout component, get specific about the metrics before you sign.
Mentally prepare yourself for a long, laborious process to define the parameters of the agreement, and make sure you like and trust the transaction attorney you engage for this project, because you’re going to spend a fair amount of time with them and your other advisors working through this part of the agreement.
Getting the language right is only half done. You’re also going to need trustworthy, responsible help, someone both buyer and seller trust, to run the numbers and monitor progress toward the target for as long as the earnout runs.
For Nevada business owners considering a sale, the lesson is simple: the work you do years before a transaction can have a very real effect on what a buyer can verify—and ultimately what you’re able to receive for the business you’ve spent years building.
Next month: a deal where the paperwork was fine and the outcome wasn’t anyway, because watching the number and being willing to say something about it turned out to be two different skills.
