5 important things to remember for earnouts when selling your business

Author: Craig Sanford, Director

When it comes time to sell your business, a large part of the negotiations will often be around the terms of an "earnout" - that is, the right of the seller to receive additional compensation in the future if the business achieves certain financial goals after completion of the sale (e.g. earnings over a specified threshold level). Based on my experience over the last 26 years buying and selling businesses, here are a few tips for sellers in relation to earnouts:

Try to avoid them!

A lot of people seem to assume that every business sale must involve an earnout, but it doesn't have to be the case. Sierra Legal recently acted for the seller of a consumer finance business, who walked away with over $10 million on completion of the deal. The buyer wanted the business so badly that there was no earnout component, and the seller received all of his consideration upfront. With no earnout and no requirement for the seller to continue working in the business after completion, the seller and his wife were able to enjoy a 12 month holiday in Europe immediately following the sale! On the flipside, when earnouts are involved, they often end in tears - after completion, the buyer will want to run the business their way, whereas the seller will often not agree with the buyer's approach and so will have concerns that this is impacting on the seller's earnout. The moral of the story is don't automatically agree to an earnout!

Assume the worst case scenario

If you have to agree to an earnout, I generally advise sellers when considering whether or not to agree to a deal, that they should assume the money they get on completion for selling their business could very well be the only consideration they receive, and that any earnout payment they get in the future should only be seen as a "bonus". Sellers often make the mistake of "banking on" an earnout payment, only to see the business going downhill after completion and their earnout disappearing. If you're not happy with the amount of the completion payment as the only payment you could receive for the sale of your business, then think twice about doing the deal. For this reason, try to get as much of the consideration paid upfront as possible, and try to keep the amount of the purchase price tied up in an earnout as small as possible (ideally, no more than 20 - 30%) and with the duration of the earnout being as short as possible (ideally, no more than 1 year).

Get good tax advice

As with any M&A deal, make sure you get advice from your tax adviser before negotiating a deal. By way of example, in some circumstances, the rights associated with an earnout can be considered by the ATO to be a separate asset for capital gains tax purposes.

Is the earnout achievable?

A positive feature of an earnout for a seller is that it can give the seller an ability to achieve a significant upside in consideration if the relevant financial goals are achieved after the business is sold (which would not have been available to the seller if the consideration had been paid entirely upfront). It is obviously crucial for the seller to protect this potential upside and ensure that it is achievable. Therefore, if you have to agree to an earnout, you need to do some due diligence on the buyer and get comfortable that the nature of the buyer and its people (and the terms of the earnout) are such that the financial goals for the earnout are achievable when the buyer is in effective control of the business.

Include earnout protections in your transaction documents

As part of protecting your earnout and the potential upside, make sure that your lawyers include comprehensive protections in the sale and purchase agreement (and other relevant transaction documents, such as a shareholders agreement if the seller is retaining an ownership interest in the business being sold). I remember seeing a sale and purchase agreement (drafted by a law firm that wasn't Sierra Legal!) which did not contain any such protections. In that matter, the seller sold all its shares in the target company to a buyer, and then shortly after completion of the sale, the buyer sold the underlying assets and business of the company to a third party. Since the company no longer had a business, it obviously couldn't generate any earnings, which in turn made it impossible to achieve the relevant financial goals for the earnout. The sale and purchase agreement should have covered this off, but it didn't … and the seller sued its lawyers! Over the next couple of weeks, I will share with you some of my suggestions for appropriate earnout protections that a seller should try to include in transaction documents when selling a business.