Selling a small business can sometimes involve an earn-out — a type of deal that links the sale price to future benchmarks the business has to hit. Georgia Swan, a Tax and Estate Planner with TD Wealth, explains what a seller needs to know and what pitfalls to avoid.
- All right, attention business owners who are planning to sell their business as part of their retirement. Let's say you are that owner selling your business, and during the negotiations the buyer says she wants to lower the price, but offer you future payments based on the growth of your company. That's something called an earn-out.
Here's the question. Should you take it? I found out earlier when I spoke with Georgia Swan. She is a Tax and Estate Planner at TD Wealth, and she started by describing what happens with an earn-out right after the deal closes.
GEORGIA SWAN: But then there's another amount that's paid to the seller over time, and that's usually tied to things like the performance of the company once it's sold-- the growth, net earnings, that sort of thing. And oftentimes, it also secures the seller to remain on with the business for a while so that they could ease the transition.
- So they spent their life building this business, they get to stay attached to it for a little longer.
- Absolutely. So it can be a very good thing in certain cases.
- OK, there's an asterisk beside that certain we'll come back to. So why do you see deals structured this way? I mean, what's the benefit to all those involved, or the cost?
- Well, whenever you value a business, a lot of times that valuation is based on the earnings. And of course, a buyer doesn't want to overpay for a business. And so in a challenging economic environment, this can be attractive to a buyer so that they don't overpay for the business. For the seller, sometimes it's their only option, because maybe there's only one or two buyers, and if they both want that kind of a structure, then the seller has no choice.
- Let's go back to when you said this is good in certain circumstances, with an asterisk beside that. You've got some stories of how these work. So why don't you tell us where there's some catches sometime?
- Well, with one seller that I was involved in, the deal took the shape of a certain amount immediately upon closing, and then there was going to be other payments that were going to be made over a three-year period pending the performance of the company and the seller staying on to ease the transition. And the seller also received some stock options, or stock of the buying company.
Problem is that the day after the closing, this person who had built this company, it was theirs, they had started it from the ground-up and had quite a love for it--
- Their heart and soul, yeah.
- Exactly-- walked in as an employee, and not an owner anymore. And the seller-- or, the buyer had their own ideas of the direction the company's going to go. And that can have a great psychological effect on the seller, who is now basically just an employee.
- When does it make sense? I mean, I want to talk about it from both sides, and when it does make sense, and maybe when it's not a good idea. You kind of highlighted one, there, where it may not be good. But when does it make sense?
- Well, it can make sense if you're going into retirement. This is a great way to kind of ease into retirement, because you get to basically still be involved in your business, but you don't have the responsibility and the headaches. As I said, sometimes it's the only option, because that's how the buyer wants to structure the deal. And sometimes it can actually, if you're this type of person, be very revitalizing, because the business, all of a sudden, has perhaps an influx of cash, new direction, new opportunities. And you, as a person that started the business, might have a lot of fun watching it grow to the next level.
- But let me ask you the counter to that. It doesn't make sense in those situations where, again, you feel like you've lost control, perhaps.
- Absolutely, where you feel like you've lost control. And I say those are the softer issues-- the psychology of the whole thing. Walking into a business, and you're no longer an owner, not being involved in that decision-making process and the direction of the company, perhaps not being a good fit with the new owner and what they want to do for the business. And some people just want to basically take their money and move on. And sometimes-- obviously, in this situation, that won't happen.
- Can you walk us through the mechanics, the nitty-gritty, of how a deal actually could happen?
- So let's say I have spent my entire life building a chemical engineering company, and it has a particular area of expertise in a very niche market. And maybe I think that the company is worth $10 million dollars. So along comes a larger chemical engineering company that wants to buy mine out, maybe because they would like to get into that niche market.
So we might structure the deal that 70% of the purchase price is provided immediately upon closing, and then the other 30% is paid out over the course of a number of years, assuming that the company meets certain sales targets, certain growth targets, and that I stay on to try to ease the transition.
So basically, once that deal closes, I come into the company-- maybe as the manager of a particular area, or as a consultant, because sometimes it doesn't have to be that you're there as an employee. It might be a part-time consultant. And then assuming that the company does meet those targets, I will get paid out over time until the deal is finished.
- Does it usually happen that way, where the majority is paid up front and then the lesser of the payment comes a little later on?
- In most cases, yes-- at least the matters that I've been involved in, that's how it is. The majority is usually paid up front, and then there's an amount that is paid out over time.
- Let me ask you-- if someone is in a situation where they are getting ready to sell and an earn-out is on the table, perhaps, of one of the ways the deal could be structured. What are some of the things you need to think about, then, to make sure that it's structured properly for you?
- First, be honest with yourself about whether you're going to be able to deal with this from a psychological perspective. Then think carefully what the earn-out is tied to. So basically, if it's tied to performance goals or something like that, are those goals realistic?
If there is an economic downturn, what's going to happen with that? Then consider carefully, are you a good fit with the company that's buying your company? Are your goals similar? And finally, the idea is just that do you want to be involved with this on a go-forward basis, or would you just like to move on?
- Great insight, Georgia. Thanks so much.
- Thank you.