Corporate partner at Kemp Little LLPView Author Profile
Focusing on the sale is understandable, but what comes next is just as important.
When you’re in negotiations to sell your business, it’s often easy to focus on headline numbers and forget what might actually benefit you in the long-term.
The fact is, earn-out clauses are often treated as ‘just another detail’ or a ‘standard’ part of the deal, when in reality they will have lasting impact on you long after you complete and so require full consideration.
Where a sale involves an earn-out, the way that earn-out is structured is the core factor that will shape your ongoing relationship with the business or govern how you maximise the value you receive.
The frustrating reality is that most acquisitions are inherently set up to fail. The odds may not always seem in your favour; according to a report by Harvard Business Review, the chance of acquisitions failing to meet its strategic goals varies between 70 and 90 percent.
Selling a business is a difficult process for a founder, especially in a people-focussed business where a lot of the responsibility for the success of the company falls directly on them and the rest of the management team.
When structured well, a good earn-out can motivate staff post-sale, and can set the parameters for a clear role for the managers to fulfil. When structured badly, they invariably lead to disputes, disgruntled managers and a general feeling of sellers’ remorse.
Here are five crucial steps when structuring an earn-out to maximise the chance of success.
Managing integration risks
Although the reasons for failure in acquisitions vary, one of the common denominators is a lack of post-completion integration planning; failure to assess the integration risks upfront, combined with failure to properly implement the integration process itself will often be the downfall of the deal.
Managing risks begins with considering how to define success. To give deals the best chance to succeed, businesses and advisers need to work together to assess post-completion integration risk.
Or, at the very least, it’s important for both the seller and the buyer to be aware of the risk of failure upfront, so that adjustments can be made to the price or expectations accordingly.
Mergers and acquisitions are rife with promises that a potential target will strengthen the buyer and provide long-term growth.
If the business owners and the acquirer have differences in views when it comes to the value of the target business, there are usually a number of justifiable reasons why this may be the case – such as differences in expectations of future revenue forecasts for a high-growth target company.
However, whilst it’s natural for the business owner to have a more optimistic outlook of the business’ value, it’s also important to remember what could potentially be at risk and whether you’re willing to reevaluate expectations.
Most owners prefer to opt for the easiest path and agree an earn-out to bridge any valuation gap between them and the buyer.
Whilst this may ensure the deal can be quickly agreed, all parties need to understand the consequences of including an earn-out and enter into the deferred consideration arrangement with their eyes fully open.
To set off in the right direction with reasonable expectations, you’ll need a buyer who understands the business, a corporate financier who’s willing to go out of his comfort zone for the right reasons, and a seller who’s comfortable that he’s not just going to deliver the same thing he’s delivered year on year.
Getting your earn-out metrics right
Most earn-outs seem to be determined based on profit / EBITDA, although some can be based on growth over time or (rarely) revenues. The reality is, though, that most owners looking to sell their business will only be thinking about the short-term gains, whilst acquirers will want to be looking long-term, and with good reason.
For a lot of technology companies, the value is based on potential future performance of the business and rarely ever past earnings. This can form an optimistic view of the business’ future profitability, which in-turn can also lead to opposing views amongst the buyer and the seller.
In most cases, it will be in both parties’ interests for the earn-out to be achievable and for the business to meet its targets. If targets are not met, this could lead to unwanted disputes or even affect the longer-term future working relationship.
Internal communication and integration planning
Communication between the various origination, deal and operation teams is key. And yet, many acquirers don’t really consider putting in place a formal integration plan until it’s too late.
This can lead to the buyer and the seller agreeing the earn-out mechanics without really understanding how the target business will be operated after conclusion of the sale.
Traditionally, certain teams only overlapped with others - such as legal and deal teams - when instructed that a commercial deal had been reached and a term sheet had been drafted.
It no longer has to be this way; business owners can now apply a holistic approach, where, rather than having one team concentrate on one specific aspect alone, risks can be identified earlier and teams can be there to support post-completion.
Setting the all-important terms for post-completion
One of the key criteria for a successful earn-out is the elimination of the risks involved with the integration project itself. If integration is an after-thought, while not surprising, it could affect the potential success of the earn-out.
By putting in place a set of integration processes - for example, identifying and empowering project leaders with experience of integration who can take charge of and pull together the various strands - the risks can be minimised.
Ultimately, by understanding post-completion risk upfront, a buyer is able to make a fully-informed decision to acquire or not, and is in a position to minimise the risk of failure if the deal goes ahead.
Earn-outs are time-consuming and easily mismanaged. With so much at stake, shouldn’t we be doing all we can to turn the outside bet into a dead cert?
Andy Moseby, Corporate Partner at Kemp Little.
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