About Earnouts… and Reducing Owner Dependence to Avoid them

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What is an earnout? An earnout means the Buyer pays for a business using the earnings from the business, usually with an initial down payment The amount due to the Seller will usually decrease if earnings don’t meet expectations

Why structure a deal as an earnout? Selling an Accounting business involves risk, ESPECIALLY when Clients (and maybe employees) won’t continue with the firm This risk is usually much higher where the business is highly dependent on the Seller ‘Dependence’ might mean that Clients or employees are highly loyal to the Seller AND/OR that the Seller produces a lot of work AND/OR that the Seller manages important processes in the business An earnout reduces the Buyer’s risk and increases the Seller’s risk because payment to the Seller is linked to business performance (earnings) after the transaction In an earnout, therefore, the Buyer’s and Seller’s goals and interests may not be fully aligned.

WHAT ARE SOME CHALLENGES WITH EARNOUTS?

In an earnout, a Seller is highly motivated to retain Clients but a Buyer may be
willing to ‘cherry pick’ the Clients they want to keep
In fact, a Buyer may raise prices or reduce service levels which encourages
Clients to leave
This negatively affects a Seller whose payment is linked to revenue and
earnings
Buyers who pay cash upfront tend to be more diligent about Client retention
while earnouts result in a higher percentage of lost clients

Continued Participation by the Seller

An earnout usually means the Seller stays on after a sale (because
they feel more ‘at risk’)
Generally, that’s the opposite of what a Seller wants… which is to
STOP working in the business
The Seller’s continued involvement prolongs their influence and
prevents the Buyer from taking charge (e.g. building strong
Buyer-Client relationships)

Disputes

Usually, the Buyer pays the Seller a fee to stay on and provide
transition assistance. Sometimes the Buyer may be willing to lose
Clients rather than continue paying this fee
Many Sellers are used to working independently without restriction but

the post-transaction environment can be challenging, leading to

conflicts

These conflicts arise because of different priorities, and are heightened

when the Seller receives less than they were expecting

The calculations associated with earnouts can be complex… leading to

misinterpretation or even manipulation by the parties

Unfortunately, there is a relatively high incidence of conflicts arising

from earnout deals

Nonpayment of Interest

In most earnouts, the Buyer pays no interest on the deferred payments,
which is prejudicial to the Seller

WHAT ARE SOME WAYS TO REDUCE SELLER RISK?

The best outcome is that the Seller and Buyer agree that post
transaction risks are negligible and agree a cash (or cash
equivalent) deal, with no earnout or contingencies. In this
case, there will probably be zero dependence on the Seller;

difficult to achieve… but entirely possible

Alternatively, increase the upfront portion (and limit the

contingent portion) to reduce Seller risk

Alternatively, make any deferred payments NOT contingent
on Client retention to reduce Seller risk
Alternatively, shorten the contingency period and adjust the
percentage of price adjustment for each dollar of lost revenue

to reduce Seller risk

Alternatively, reduce the purchase price so the Seller can get

better terms (more upfront, less contingency) to reduce Seller risk

ANY OTHER TIPS FOR A SELLER?

A seller should define their priorities. What is REALLY

important? The business valuation, payment terms, post

transaction obligations, creating a legacy, something else?

There may be a need to compromise… but a clear sense of the

priorities helps secure the most important outcomes

Remember, a cash deal also benefits the buyer, who can take

control of the business quickly

In many cases, earnouts are necessary to protect the buyer,

specially where there is a risk of a seller competing with the

firm OR there is high dependence on a few large Clients

All owners should set out to reduce dependence on

themselves. In that case, earnouts become virtually irrelevant

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