Using an Earnout Provision to Advance a Store Purchase
Buying or selling a dealership can be stressful – it may be the largest financial transaction you’ll ever make. And when you have an interested buyer (or seller), but are nowhere near settling on the purchase price, the situation can become disappointing. Before tossing in the proverbial chips, you might want to consider an earnout provision. It may spur you on to closing the deal.
Come up with an alternative
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 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.
Accept a lower payment up front
In an earnout agreement, the seller typically accepts 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 an auto dealer 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.
Develop financial milestones
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 the 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. Your CPA can help develop or assess ideal targets in an earnout arrangement.
Understand the dangers
During the life of the agreement, various factors might affect the buyer’s ability to meet financial targets. Thus, the length of time in which postclosing payments will be made can be a risk factor. Three years is generally the longest term covered by an earnout provision.
Other examples of risk: The new owner might decide to take on the costs of an expensive renovation project or relocate the dealership. If the buyer decides to write off a portion of the renovation project’s expenses or the move, 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 protective measures so that the seller is adequately paid. Such measures could include restrictions on owner salary and compensation or on rent increases, or ceilings on the amount of capital expenditures allowed per year.
A keen understanding of every risk facing the dealership is essential to crafting the right targets and identifying the contingencies to attach to each.
If you’re considering an earnout provision in the sale of your dealership (or the purchase of another store), consult your attorney and your CPA. Many legal and financial issues need to be ironed out before entering such an agreement.
Dealer Insights - July-August 2016