4 Steps to Structuring an Earn-Out Agreement: Part 3 – What’s Your Role?

By Generational Equity

08/16/2017

“Before entering an earn-out agreement, ask yourself: are you ready to work just as hard as you did as owner to ensure the terms of your deal are met? If you’re not, then this type of deal structure probably isn’t for you.”

Hopefully you enjoyed part two of our series on structuring earn-out agreements, which discussed the importance of knowing how to value a company and having a clear idea of your company’s growth potential. Without this information, it is highly unlikely that you will set realistic targets that your business must fulfil to receive the optimal return. While our first two parts of this series have concentrated on the financials and figures that will form the base of any earn-out agreement, it is time to turn to another essential aspect of a successful deal structure – what role you will play in your company going forward.

Our dealmakers at Generational Equity have assisted in the structuring and implementation of many earn-outs over the years, and it is common for the previous owners to be contractually obligated to stay with their business in a new role. There are several reasons for this that can benefit both business buyers and owners interested in exiting:

• For buyers, they will benefit from the guidance and assistance of the individual that likely knows more about their acquisition than anybody else. The previous owner(s) will have been chiefly responsible for the development of the business, and their support will be helpful in achieving the best return on investment.
• For exiting business owners, this element of the earn-out agreement allows them to stay involved in the continued growth of their company and play a decisive factor in ensuring that all expectations agreed upon in the deal are realized. This way, they may be able to earn a greater return than an immediate transaction.

So, having the former business owner on board during an earn-out agreement, either as an employee or consultant, means they can influence the conditions required to receive the optimal return on investment.

Are you prepared to earn your earn-out?

As the business owner, your priorities and ambitions post-exit play a vital role in the structure of your earn-out agreement. If you have no intention of staying involved in your business following its acquisition, whether because you wish to pursue other ventures, devote more time to your hobbies or spend quality time with your family, then we would strongly advise you to not pursue an earn-out deal.

The primary reason for this is that you would not be involved in fulfilling the terms of your agreement, which is a considerable risk. As we mentioned in part one, there is potential for financials to be manipulated by those involved to avoid paying the maximum price for your company. Your best chance of guaranteeing this doesn’t happen is to remain part of the business for the duration of your agreement, and only exit entirely when all conditions have been met.

This will involve a lot of effort and commitment – maybe just as much as you were putting in when you owned the company. So, before entering an earn-out agreement, ask yourself: are you ready to work just as hard as you did as owner to ensure the terms of your deal are met? If you’re not, then this type of deal structure probably isn’t for you.

Establishing your new role

If you are prepared to stay involved in your business in some capacity as part of your earn-out, it is critical that your new role is not ambiguous. We strongly encourage you to work alongside a skilled M&A advisor during negotiations to clarify what your role will be, what it will entail and how it will influence the execution of your deal structure. It is pointless to set milestones to achieve the optimal return on investment and then not have any responsibility over the duties required to reach these goals.

For instance, if your earn-out is based on net income improvement of 10% over the next three years, you should be given a role that helps make this happen. Our team at Generational Equity have encountered numerous business owners who did not use M&A advisor and realized too late that they had no bearing on the fulfilment of their expectations, which meant that they did not receive the maximum return. That is why it is so important to hire an experienced M&A advisor, who can help you navigate the potential pitfalls of earn-out agreements and allow you to reap the benefits of this exit strategy.

If you find yourself unsure about how to form your exit strategy around your business ambitions, you should attend one of our complimentary executive conferences. Not only will this offer an effective insight into the different kinds of deal structure, including earn-out agreements, but also help you to establish your true motivations for exiting your company and how this will influence which approach is best in accomplishing your goals.

Contact our team at Generational Equity today for more information on how we can support your professional ambitions and build your successful exit strategy.