You’re the Boss Blog: One Way to Close the Sale of a Business

Jane Johnson

Transaction

Putting a price on business.

I once worked with a man whose license plate read BCRE8VE (translation: Be Creative). It was the perfect mantra for a director of advertising — and equally fitting for business owners and deal makers navigating today’s business-for-sale marketplace. While there has been a slight uptick in business sales of late, getting a deal done with tight credit markets, depressed valuations and skittish investors continues to require as much art as science.

There’s a common saying that buyers will pay you only what your business is worth today. If sales and earnings at your company were stellar three years ago but have since dropped off, the buyer is not going to value your business at the previous year’s level. If your business has the potential for growth in the coming years, particularly in the hands of a strategic acquirer, then a buyer may indeed pay you for that future value — but don’t expect the payment today. Instead, be prepared to understand and structure an earnout, a contingency payment that is based on the future performance of the business.

A flexible tool that can be used in combination with other terms of a sale to arrive at a mutually agreeable price, an earnout can serve a number of purposes, including making up the difference between what the seller wants and what the buyer is willing to pay, backing up seller claims about future growth opportunities, and balancing out perceived risk.

Earnouts are used frequently in the sale of high-tech and service businesses like CoActive Consulting Group, a 15-person firm that installed and automated software systems at companies throughout New England and that Jane Johnson and her partners sold in 2004. At first, when a buyer put in a weak initial offer, the deal looked like a nonstarter. But then Ms. Johnson started thinking creatively.

“Rather than give up, I built a spreadsheet that showed the synergies between our companies and future revenue and profits we could make together,” said Ms. Johnson, who started CoActive in 1990 to give herself a more flexible schedule while starting a family. After working with the buyer, a Boston-based accounting firm with more than 250 employees, on several consulting assignments, Ms. Johnson and her partners were confident the two companies would be a good fit. “I was determined to make this deal work,” she recalled.

Most earnouts involve structured payments to the seller that are tied to milestones like gross sales, gross profit or net income, with a typical term of one to five years. “We agreed on the assumptions for the spreadsheet and successfully negotiated an earnout based on both new business as well as recurring revenue from our existing customer list on the date of the sale,” Ms. Johnson said of CoActive’s earnout. “It was based on gross consulting revenue and software margin, not the buyer’s bottom line. We did not want to be penalized for their overhead spending.”

Earnouts work well for the sale of a business whose primary stakeholders are willing to stay on and ensure that the agreed-upon milestones are achieved. “I knew that I could put aside my ego and work for someone, at least for a few years,” said Ms. Johnson, who was CoActive’s chief executive. “I had worked successfully in larger organizations in the  past, so I knew I could do it.” Each of CoActive’s partners had a five-year employment agreement, although the agreement was not contingent on the partners staying on. After selling CoActive, the partners received payments from the buyer every six months for the next five years.

Earnouts have become particularly relevant during the recent economic downturn, as they can also be useful for businesses that have experienced a downward trend in revenues — a situation that many business owners now face. One of the disadvantages of selling your business is that you forgo any benefit from the company’s future growth. An earnout can facilitate a sale today, while allowing the seller to enjoy some of the upside that comes with improved economic conditions. Earnouts can also minimize the tax consequences associated with the sale of a business (be sure to discuss the tax consequences of any deal structure with your advisers early in the negotiation process).

Setting up an earnout does involve certain risks. Chief among these are delaying payment in full, reliance on the buyer’s operational skills, and the prospect of unanticipated disputes surrounding the earnout’s structure and payout. Business owners should try to strike a balance between the potential risks and rewards. “We realized a much larger payout than we could have ever received if we took all cash up front,” said Ms. Johnson, who received the majority of the sales price of CoActive through the contingency. “We decided to shoulder most of the risk, and it paid off.”

Since selling her business, Ms. Johnson has been specializing in exit- and transition-planning for business owners.

Barbara Taylor is co-owner of a business brokerage, Synergy Business Services, in Bentonville, Ark. Here is her guide to selling a business.

Article source: http://feeds.nytimes.com/click.phdo?i=eb2725e7f19a3df4ee7a1d723ca63e08