Best earnout framework?

by a searcher from Harvard University - Harvard Business School

4 years ago

I'm in discussions with the owner of a small b-b and b-c service company that is slightly profitable.  Successful transition will require his continued involvement for 1-2 years.  I'm considering an earnout framework and am looking for ways to make it easy to keep it clear, aligned and successful.  Any experience to share?  Thanks.

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searcher from Ohio State University

Hi there. I posted about earn-outs in one other thread here. I suggest having the seller retain a portion of the equity to align them with you over the next few years, and/or give them a profits interest or options that vest according to time and performance metrics if you think you'll sell the business within a reasonable time frame. If you don't think you'll "exit" the business within a few years, consider giving them a put-option so that they can realize the value of their minority equity assuming the business performs well. I also have a friend who gave a Seller a royalty on the revenue of the business to keep the Seller motivated to help grow the business/protect key customer accounts without actually owning any equity. If you decide to allow a minority shareholder, I echo Ian's comment: an operating agreement with drag and tag and other rights is critical in my experience.

4 years ago | like reply | 1 like

searcher from University of Dallas

Talk to your CPAs and get the tax components modeled out in a sheet:
1) There are tax structures for earnouts that are important and can really help you if you do a stock sale
From a tax perspective. There is a business credit to the acquirer if you can get a 15 year earnout structure. (yes 15 years) but the government lets you write part of that off if you can pull it off. We did it for one acquisition and it just made sense for everyone.

2) Get a VERY clear operating agreement done with a lawyer that has the terms of the person for 1-2 years that will obligate them to that and have holdbacks should someone get hit by a bus.

Earn-out rates paid out vary from between 0% interest to roughly market interest rates of 5-6.5%. I've seen them higher but paying market rates for debt is generally considered fair.

The solution for this problem is simple. Low-interest rates over a longer term is better for growth and returns and reduce risk. Lenders want to lend short borrowers want to borrow long. You want to borrow over a long term at a low rate. The seller is your lender. Get as much as you can while still being fair and finding something that works.

4 years ago | like reply | 1 like

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