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Dealer Insights - July/August 2013 - The Ins And Outs Of Earnouts

They can seal the deal, but be sure to think it through

It’s one of your worst nightmares: After years of hard work, you’re ready to sell the dealership and enjoy your golden years. Your business has been on the market for months, and you finally find a potential buyer. But when it comes to the selling price, you’re miles apart — what you think the dealership is worth vs. what the buyer is willing to spend is at odds, and there’s no solution in sight.

Don’t lose hope yet. Consider adding an earnout provision to the purchase agreement. One of these can help seal the deal in stalled sales negotiations and get you on your way to your life’s next chapter.

WHAT IS IT?

An earnout provision is contractual language that commits the buyer to make additional payments to the seller if the business achieves agreed-upon financial targets after the sale. Sometimes earnouts are called “payouts” or “contingent payments.”

Earnout arrangements can be the answer when the seller and the buyer disagree on the purchase price, and the seller believes, simply stated, that the business will do well. An earnout also can be useful when the buyer can’t come up with the full purchase price, and the deal will collapse without seller participation.
 
HOW DOES IT WORK?

In an earnout agreement, the seller typically accepts at closing a payment lower than the asking price and maintains an interest in the business. As mentioned, if the agreed-upon financial targets are met during a specified period, the seller will receive additional remuneration. Some earnout provisions give the seller the right to claim company assets if the buyer fails to meet the payment schedule.

Say that the owner of an auto dealership is firm with a $2.5 million asking price for his business based on projected earnings. But the buyer is only able to pay or finance $2 million. The two parties could agree on an earnout provision whereby the seller will be paid $1.75 million at closing and receive payments totaling $250,000 over the next three years. These payments would hinge on the dealership achieving, for instance, $20 million in gross annual sales for each of those years.

WHAT ARE THE TARGETS?

A crucial part of an earnout provision is developing the financial targets or milestones. As noted, these will entitle the seller to be paid the balance of the purchase price. Set targets carefully, making sure that your dealership’s new owner will likely achieve them.

The targets might involve gross sales, as in the example above, or some other metric, such as the number of new and used retail units sold or gross profit percentages by department. A different metric: A buyer might agree to pay the seller, for instance, 20% of annual earnings that exceed the previous year’s earnings by a certain amount. A CPA can help develop or assess ideal targets in an earnout arrangement.

HOW CAN YOU MANAGE RISK?

During the life of the agreement, various factors might affect the buyer’s ability to meet financial targets. For example, the length of time in which postclosing payments will be made can be a risk factor. (See the sidebar “How long is long enough?”)

Other examples of risk: The new owner might decide to relocate the dealership or take on the costs of an expensive renovation project. If the buyer decides to write off a portion of the move or the renovation project’s expenses, the resulting change could lower earnings, causing the seller to lose out on one or more earnout payments.

To guard against this scenario, both parties need to identify any contingencies — the “what ifs” — that could affect the buyer’s ability to meet the financial targets. Moreover, they must build in some protection measures so that the seller is adequately paid.  Such measures include:

  • Restrictions on owner salary and compensation,
  • Dividend distributions,
  • Ceilings on the amount of capital expenditures allowed per year, or
  • Restrictions on rent increases.

As you can see, a keen understanding of every risk facing the dealership is essential to crafting the right targets and identifying the contingencies to attach to each.

WHAT’S ACCEPTABLE?

An earnout provision can eliminate uncertainty for buyers and provide sellers with additional postclosing payments they might not otherwise receive. But, whether you are the seller or the buyer in such an arrangement, tread carefully. Make sure that the details of the agreement reflect what you’re willing to accept.

Sidebar: How Long Is Long Enough?

Three years is generally the longest term covered by an earnout provision. A longer period can subject the seller to greater risk, because it increases the possibility of adverse business events — for example, a new competitor, a consumer credit crunch or a major economic downturn — that are beyond the seller’s control.

If a longer period is sought, the seller could consider financing in the form of preferred stock in the dealership or a loan. Both of these alternatives give the seller recourse in case the business is mismanaged and the buyer can’t meet his or her financial obligations.

Dealer Insights - July/August 2013 Issue 

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