Transitioning ownership in the new reality
Transitioning to new owners is a challenge due to COVID-19, but one avenue to consider is an earnout, which can benefit all sides involved.
The challenge is obvious: as a selling shareholder, you want to sell for a price that reflects the value of the firm you’ve built, probably over decades. Yet with so much uncertainty ahead, buyers may not want to take the risk of promising you that full payout.
One avenue to consider is an “earnout” – that is, to make the ultimate price you get contingent on the subsequent performance of the company. If the firm’s business proceeds as expected, sellers get the payout they expect. If it deteriorates, they forego some of their payout for the good of the firm. If the firm’s performance takes off, they get to share in the wealth and receive a higher payout than they otherwise would.
To see how it works, imagine a firm with $15 million in net revenue and a 12% profit margin, with a valuation of $10 million. In a simple sale, the sellers would just get $10 million in cash, paid over a period of several years. With an earnout, those guaranteed payments might be reduced to $6 million, with an earnout that ranged from $0 if the company’s profits declined to $8 million if they accelerated. The sellers take some risk, but in this scenario they also have the opportunity to increase their payout by 40% if the company is highly successful.
From a buyer’s perspective, the earnout means less risk. In the A/E industry, internal buyers usually have to take out loans, either from a bank or the company, to pay for their stock. If all goes well, the firm generates enough profits that the buyers can use their distributions to pay back the loans. But if the business runs into difficulty, the distributions dry up and the buyers have to pay the loan out of their own pockets, a burden which can be substantial. An earnout can ease some of the financial pressure by reducing the required payments if the firm is less profitable. On the flip side, the earnout will attenuate some of the buyers’ windfall if the firm’s profits grow rapidly.
Earnouts have another advantage: they give the selling shareholders a strong financial incentive to help enable a smooth transition, transfer skills and client relationships to the new partners and be available for mentoring. While most selling shareholders are eager to do this anyway, a financial incentive always helps.
As an additional means of mitigating risk for both buyers and sellers in the near to medium-term, the parties may agree to an option to extend the purchase and sale period by one or more years. Think of this as the opportunity for a “mulligan year.” If performance one year lags – for instance if a firm’s normal base of clients is hurt by COVID-related delays – the parties may agree to simply suspend share payments that year and extend the term of the loan to give the firm time to recover. Payments resume with interest when performance normalizes.
Earnout provisions in buyouts may be useful in normal times, and they are regularly used in external sales with an asymmetry of information between buyers and sellers. They’re currently less common for internal transitions (likely due to the added complexity) but the benefits are undeniable, especially in uncertain times like the present.