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How to Bridge the Gap Between the Buyers and Sellers

How to Bridge the Gap Between the Buyers and Sellers

June 24, 2008

Another solution to help you profit from the biggest trend in America

Last month, I told you how the biggest trend in American business is about to take off and gave you some suggestions on how to profit from it.

I'm talking of course about the millions of baby boomers who will begin to sell their businesses as they retire. For sellers, however, the statistics aren't encouraging because many of them will leave thousands of dollars ' if not millions of dollars ' on the table.

Only 11% of the businesses for sale get the price they should, says buy/sell expert Tom West, founder of the International Business Brokers Association. Author Harvey Zemmel of the book, The Secret to Exceptional Wealth, estimates that figure is even less, at only 1%. That means 89%-99% of business owners are getting less than full value.

Here's a typical scenario: A buyer is interested in acquiring the business but won't budge on an offer that's below the seller's asking price. When pressed, the buyer says he's concerned about declining revenues and falling profits after the transition and has made it very clear that he's prepared to walk away from the deal if the offer isn't accepted.

Consider yourself the seller. You feel the buyer is the best choice for your company and can continue to grow the business that you started.

What do you do?

Accept the lower offer and move on? Or, try to push harder for the higher price and risk losing the deal?

The deal-saving alternative

Before you answer, here's another option to consider that's becoming more common in deals, especially among small businesses: an earnout.

As many as half of all small business acquisitions involve earnouts in which a portion of the purchase price is paid to the seller if certain earnings targets are met over a period of time. Generally, earnouts last two to four years and range from 15% to 30% of the purchase price (though 50% is not unheard of), according to BusinessWeek.

'An earnout can be a win-win for both parties,' says business broker Gregory Caruso, Harverst Associates, LLC (www.BusinessHarvest.com) and author of 11 Secrets to Selling Your Business. About 50%-70% of the deals he brokers involve an earnout, he says.

Interestingly, earnouts often land the seller a premium above the buyer's best offer, Caruso says. 'Wouldn't you pay more if you knew the seller was going to be around to help with the transition and help make sure the business remained profitable after the sale?'

Take the scenario described above in which the buyer is holding firm at his offer to buy the business at say $1.8 million, even though the seller may be asking for $2 million. In that case the seller may propose to increase the base price to $1.9 million and have the remaining difference of 100,000 paid in an earnout over the next three years if certain target revenue numbers are met.

The buyer may be more comfortable with the deal because the business owner has an interest in seeing the business perform well after the sale. And the seller gets the additional money he was seeking as long as the targets are met.

An earnout may also be the ONLY way to close some deals

For professional service businesses, such as a doctor's office, chiropractic office or a printer in which the business owner is the business, an earnout is often the only way to sell it, says business broker Ron Van Orden (California-Business-Broker.com),VR Business Brokers Mergers and Acquisitions.

For example, one real estate appraiser whose business is dependent upon his relationships with lenders and real estate brokers recently agreed to sell his business with an earnout that amounts to 70% of the purchase price. He also agreed to train the new owner for three months and help the buyer secure those relationships that are vital to the business' success.

'In those situations, the buyer wants the owner to have some sort of stake in the business,' Van Orden says. 'A lot of times it's a deal maker.'

WARNING: There are plenty of horror stories in the press about earnouts that never get paid. There are stories of new owners who stopped working with the sellers' clients or buyers adding large expenses such as a new computer system or health plan in the first year, driving down profits and therefore the earnout.

Caruso estimates that his clients collect on earnouts more than 50% of time ' better than nothing at all, which would be the situation if an earnout was not included in the sale.

But there are times when a seller doesn't see a dime of the earnout.

For example, Caruso is dealing with a situation right now in which the buyer is suffering from severe health problems six months after he acquired the business. The business is floundering and the seller does not expect to see the earnout as he had anticipated.

TIP: Base the earnout on metrics such as revenue that are easy for both the buyer and seller to calculate, Caruso advises. He advises most of his clients, especially small businesses, to peg the earnout to top-line sales.

Mid-size companies can use metrics such as earnings before interest, taxes, depreciation and amortization (EBITDA), he says. If the selling company will become part of a division, base the earnout on the revenue of just the division, not the performance of the entire buying company, he says.

Bottom line to sellers: If you need the earnout money to make the deal work, don't do it. An earnout should be considered 'bonus money' and nothing more, Caruso says.

'I tell all my sellers, 'If you need to collect substantial money downstream in an earnout for this deal to make sense - then think real hard about doing it.'

An earnout is never guaranteed income and should only be considered if the buyer and seller simply can't agree on the price. If the seller agrees to an earnout, the buyer is more likely to pay more money knowing the seller has an interest in making sure the business continues to grow. In return, the seller may earn additional income over a several year period.

Earnouts at a glance from the perspective of the buyer and seller

Here's how an earnout helps a seller:

  • Bridges the gap between the seller's asking price and what the buyer is willing to risk paying.
  • Adds more leverage when negotiating for a larger base purchase price.
  • Creates the possibility of additional revenue two or three years after the sale.
  • Secures a sale that may not otherwise occur.

Here's how it can helps a buyer:
  • Mitigates the risk of the business performing poorly after the sale, because the seller still has a financial stake.
  • Helps transition key relationships with customers and vendors to the buyer.
  • Helps new management learn how the business operated previously since the seller is available for 'training' or 'consulting' after the sale.
  • Helps management understand the market with the seller's advice.

Don't want an earnout?

Here's what you need to do right now.

When most sellers walk into Ron Van Orden's office, they don't want to even hear about earnouts. 'They hate them' because they won't be able to just cash out and walk away from the business, says Van Orden, VR Business Brokers Mergers and Acquisitions.

But once sellers realize they may not be able to sell the business without an earnout, he says they gradually warm up to the idea.

There are things you can do so you may never need an earnout when selling your business.

The best thing you can do is to structure your business so it can operate without you, Van Orden says. 'I see a lot of situations when it comes time to sell, you can't extract the owner of the business because the owner is the business,' he says.

QUESTION: When was the last time you took a vacation? If you haven't taken a vacation in five years because you feel the business would fall apart, that's a clear signal that the business will probably collapse after you sell it.

Go take a vacation and learn what falls apart so your team can learn to operate on their own. Then you can start building systems and people to plug the holes in your organizaton, which will give you the freedom to sell your company in the future.

If you have 'hand-shake' deals with vendors, put them into a contract so those relationships will continue even if you're not there. Take the systems that are in your head, and put them down on paper for others to follow.

For more on how to free yourself from the business, go to the archives to see how to create Freedom Systems.