Many factors play a role during the sale of your business. Continuing to run your business, preparing it for future profitability, and finding the right buyer may be overwhelming at times, even with the help of a M&A advisor and legal counsel. To add on top of that, you will also be negotiating a purchase agreement and employment agreement throughout the process.
Besides knowing what to generally expect when moving into the sale process, you should know what to expect when negotiating your earnout. Both parties will typically negotiate a deal that benefits both parties once the acquisition is complete. A seller will want to maximize their potential upside in an earnout – increasing their overall purchase price consideration.
So, how do you go about negotiating an earnout? Here’s a guide on what the most negotiated points in an earnout are.
Are you interested in getting expert support through your M&A deal? Contact Clare Advisors today to learn how your agency can benefit from some help!
What Is an Earnout?
An earnout is a provision written into a transaction structure that provides for conditional payments from a buyer to the seller in which a portion of the overall purchase price is paid out. Not every deal structure will include an earnout, but it is fairly common in the advertising and marketing industry.
Typically, an earnout payment is contingent upon achieving pre-defined financial thresholds or operating milestones post-transaction. If you’re interested in selling your firm, you’ll want to sell when you have the most potential for revenue and profitability growth in your earnout term. In other words, if you can utilize the momentum of your business to project an upswing in your revenue and profit, you’ll be more likely to maximize your potential upside in an earnout – increasing your overall purchase price consideration.
Why Is Negotiating the Earnout Important?
In many purchase agreement negotiations, buyers want to protect against as much financial risk as they can when acquiring an agency. A common method to minimize financial and operational risk is paying a portion of the overall purchase price consideration through an earnout that depends on the acquired agency’s revenue or profitability.
Creating an earnout structure can involve many factors and negotiating the terms to be favorable to both parties is essential for both parties maximizing the earnout to the extent they can.
An earnout is a great incentive for both parties to work towards higher profitability as the earnout payment(s) will increase for the agency owner and the buyer realizes higher EBITDA from the agency it now owns.
What Is Taken Into Consideration for the Portion Paid at Closing?
Most of the time, a transaction will include a portion of the consideration paid at closing. The amount will vary depending on a few factors, such as the closing valuation. Although the valuation of a company is considered when negotiating the cash at closing and the structure of the earnout, the agency is revalued at the end of the earnout period to consider the increased profitability is.
The buyer also looks at how much they may be willing to spend at one time. Some may break it out as a smaller amount at closing and one or two guaranteed stub payments in the next year or so. Depending on how the deal is financed, a buyer may only be allowed to use a certain amount of the overall purchase consideration at closing.
The financial risk of the acquisition is also taken into consideration. If the seller is unprofitable at the moment or there is a higher level of financial risk, a buyer may push to pay less upfront and base more of the overall purchase price consideration on the earnout portion. With the earnout being based on the revenue or profitability of the agency, the seller is incentivized to ensure the agency performs well to maximize the earnout.
An earnout works as a safeguard for both the buyer and seller.
What Are the Most Negotiated Points in an Earnout?
So, you may be prepared to start working towards an earnout structure that works. However, you may not know which key points to work towards. Some important points are typically negotiated so both parties can be satisfied with the outcome.
With the earnout, both sides need to agree upon the following.
1. What Type of Earnout It Is
There are two types of earnout structures that can be used. The first is revenue based, focusing on the agency’s revenue during specified periods. The seller would be incentivized to bring in as much new business as possible.
The other is profit based (EBIT or EBITDA), similar to a revenue-based model. However, it forces the seller to consider all of the operations and expenses that go into the business, and ideally maximizes profitability.
2. The Earnout Term
Some sellers want to exit once the deal is closed. In contrast, others may want to continue doing what they did, but with extra financial, operational, and business development support from the parent organization. Understanding the level of involvement that will be expected of you after a sale is important when initially deciding between offer letters from buyers and then negotiating with the final bidder. Realistically, the earnout term mostly depends on what the buyer is willing to accept.
3. How The Payments Are Calculated
A major negotiation point of an earnout is figuring out how the payments will be calculated. This ensures that the seller knows what period of time the earnout payment will be based on and the buyer can also project how much and when they will be expected to make the payments. Some questions to ask that will help establish how the payments will be calculated include:
- Is the payment a percentage of revenue, EBIT, or EBITDA?
- Is there a threshold the agency has to meet before the percentage is activated?
- Are the payments scaled?
- What clients or work count towards the earnout?
- What if the parent agency gives the seller the work to do?
- What if the seller brings the lead?
4. When the Seller Gets Paid
Another point to negotiate and agree upon is the payment plan. Does the seller receive quarterly or annual payments? If f quarterly, how long after the quarter is over does the seller get paid?
Why Should You Work with Clare Advisors?
Negotiating an earnout structure that works can be complex, just like the rest of the sale process, but getting help from merger and acquisition specialists makes the process easier and ensures that you’re getting everything you need for the M&A deal.
Clare Advisors is an M&A advisory firm with decades of experience in mergers and acquisitions in the marketing and advertising industry. Our team provides M&A advisory services through every step of the process, so you’ll never be unsure what to do next. We can help you no matter the sale type and help you get your agency in the best position for a smooth sale transaction.
Are you ready to ensure that your earnout structure is accurate to your business? Contact Clare Advisors today so our expert team can help you!