Many plant owners are starting to plan for retirement, or at least winding down on responsibilities. Because this brings up a host of challenges, it’s never too soon to start the process.
Part 1 of this story discussed initial considerations for making the transition, along with all-cash sales and buyouts. Another type of transition is the earnout.
The intent of the earnout is to accomplish two things. It can allow the seller to remain with the business, maintaining control until paid out, and it bridges the gap between the price the seller wants and what the buyer is willing to pay.
The earnout is a payment for performance after the deal is closed. After the sale, if reaching or exceeding a certain agreed-upon financial target or other milestone during a specified period, the purchaser pays the seller additional compensation pursuant to an agreed-upon formula.
Buyers traditionally buy based on historical performance, whereas sellers want to include in their valuation and price an increment for potential growth and increased profits. When the seller’s price can’t be justified by possible growth, an earnout is a logical way to cover the gap. It protects a purchaser who doesn’t wish to overpay for potential, and a seller who doesn’t want to leave money on the table.
This type of agreement works well if you’re selling over time to an outsider. An employee would already have a good idea of the value and potential of the business, so a buy-in with a fixed price would be the better route.
For example, let’s assume that during the past three years the average net after-tax profit of your drycleaning plant was $60,000. Using a 15% capitalization rate and basic valuation method, a buyer would likely value the business at $400,000 ($60,000 divided by 0.15).
You’re convinced that the revenue and net profit will increase at least 3% per year for the next five years. Compounding the 3% per annum, by the end of year five, the net profit will be $69,558. Using the same 15% capitalization rate, your plant will have a "going-concern" value of $463,720. You think this is what the buyer should pay.
With the earnout, the buyer agrees to the basic price of $400,000. If the business does increase at an average rate of 3% per annum for the next five years, and in year five does net $69,558, he or she will pay an additional $63,720 and the deal is done. Up to a predetermined cap, all increased net profit amounts above the base (here, $60,000 per annum) would be prorated on the same basis.
Other calculation methods could include so much per annum based on the business’s profit threshold, an agreement based on gross revenues rather than after-tax profits, a higher discount rate if earnings are lower than anticipated, a cumulative earnout that is based on annual profits during the entire contract period, etc.
Because they hold an increased potential for conflict, an earnout agreement must be drafted precisely and followed to the letter. The rules must be clear and easy to carry out. It’s very important that the method used to calculate future earnings is spelled out. It’s not good enough to say they will be computed according the generally accepted accounting principles (GAAP). Be specific, and make sure you employ the best available lawyers and accountants to set it up.
It can’t be said too often: Phasing out — transitioning out of active business management — must be planned. It can never be a case where you simply say that on an appointed day, you will walk out the door with a wad of money in your jeans. An exit in which your health, wealth and reputation remain intact takes meticulous planning and methodical execution.
Start now — not “someday” when it becomes a do-or-die situation, and you have to get out. Consider your options, select the one that works best for you, get the best legal and tax advice, and do it.
Click here for Part 1 of this story!