Dashboard: It’s Not That Earnouts Are Bad. It’s That Bad Earnouts Are Bad

Speaker B Yeah, so an earnout means that when you sell a business, some portion of the consideration being paid to the seller is based upon the performance of the business after closing day. And so sometimes when there's a disagreement as to the value of the business, an earnout will be the solution. So if a business owner believes that there's, you know, a very optimistic future for the business and all kinds of reasons why profitability is going to continue to grow, et cetera, and a buyer, you know, is a little hesitant on that, they might say, well, let's create an offer where if those conditions actually do arise, then you will end up with some portion of that growth or extra money. And so that is what an earnout is. It means that some portion of the earnings going into the future end up in the seller's hands. And it means that if the business fails to perform under those required conditions, then the seller doesn't see that extra money.

Loren Feldman Now, for years I have heard people who have experience in buying and selling businesses say that whatever sellers do, they should avoid earnouts at all costs. Tell us what's the case for earnouts, Dave?

Speaker B Well, I, you know, let's talk words here first, because one of the things that Josh and I talked about when we ran into each other on one of our meetings here a couple of weeks ago is that people were using different words to mean, or the same word to mean different things. So there's many different varieties of what I would classify as deferred compensation when someone sells a business. So you could sell a business and not get all of your money on closing day, but have a very defined amount of money that is supposed to be paid to you with a strict monthly payment plan. That would be referred to as seller financing. That's a seller note. And that would be basically the seller acting like a bank financing part of the transaction, which is not an earnout, right? And then there are other—

Loren Feldman Because it's not discretionary. It's not dependent on meeting certain goals or metrics. It's money that is owed.

Speaker B Right. And then you can have other varieties of deferred compensation as well. You could have a, for example, a business where the seller owns the building and the buyer buys the business and becomes the tenant, you know, and then they pay rent to the seller. You could have some sort of intellectual property that maybe the buyer doesn't acquire, but they pay a royalty to the seller. You could have a seller that sells the business and then becomes employed under some kind of consulting agreement, which may be extremely generous, right? So there's all kinds of different ways that post-closing money could be structured for different reasons under different circumstances, either to the benefit of the buyer or the seller. And in general, what's happening is buyers, if they can't get all the money that they need to buy the business easily from other funding sources, then they will often look to the seller to create some sort of arrangement with deferred compensation of some manner. And the reason why that is important to the buyer is it allows them to actually do the deal. The reason why it's important to the seller is that through being open to some kind of deferred compensation arrangement, they are opening the door to a higher price than if they insisted on getting cash on closing day. And the real thing that the buyer is trying to manage is risk because a business owner has operated their business for a very long time. They know the ins and the outs of the business. They understand all of the risks inherent in the business. They know how it operates. They know everything about the business. The buyer comes along and often they are new to the business. they do some kind of due diligence where they try to learn as much as they can about the business, but they will never know as much as the seller. And so they are in an information deficit when they're making this negotiation, and they're worried that the seller knows something that they're not disclosing that is going to be a negative piece of information about the future of the business. And so these deferred compensation, deferred payment methodologies are often tied, like in the in the form of an earnout tied to future performance. But even a seller note could be tied to some kind of offset clause, like the note might be subject to offset in the case of material misrepresentation or something like that. So it allows the buyer to be more comfortable going into the deal, knowing that there are potentially ways to alter the deal if they need to after closing, if it turns out that they've been the victim of misinformation or outright fraud.

Loren Feldman If I recall correctly, your view is that earnouts shouldn't, by definition, be viewed as a problem for a seller, but can in fact be a mechanism to get everybody on the same page, aligned, working together, producing an outcome that is better for both buyer and seller. Is that What do you think?

Speaker B Yeah, well, it allows for a buyer to make a higher offer than they might normally be able to make, because if they, if they are making an offer strictly on what they know to absolutely be true, they can't obviously make a deal based on something that could happen in the future. So you're, you're opening the door to further compensation to a seller if things do indeed turn out to be the way the seller claims they will be.

Loren Feldman Josh, do you have a problem with that?

Josh Patrick Not if it's structured properly. And I generally don't like earnouts because what happens is I've sold my business to you. You now control my old business, and if you make really crummy decisions, I get no earnout. That's my biggest problem with earnouts. I, and I see that happening A lot, especially if we're in the world of private equity. They often will buy a business, think they know how to run it, but they end up running it into the ground. So the seller who thought they were going to get 20, 30, 40% of their purchase price don't receive anything. And I don't know if—

Loren Feldman After the initial sale?

Josh Patrick After the initial sale. They get, you know, they get say 60, 70% down and the 30% they expect through earnout or more never appears because the buyer has no idea how to run their business. And what that really comes down to in my world, or my opinion, is buyers, I mean sellers doing due diligence on the buyer. Do they know what they're doing? Do they have an idea how to run my business? What are they going to do with the business once they take it over? And buyers and sellers always lie, so it's hard to figure out what's true and what's not true. And the thing with, I was reacting to with David was really more around owner financing than earnouts. And I, And I think I did what David says lots of people do is we, you know, take one word that means one thing and we put another word in place thinking it's the same and it's not.

Loren Feldman Dave, did that make sense to you? Do you see the situation that Josh described? Is that a common occurrence in your world?

Speaker B Well, it depends on how the business owner has been prepared. So, and this is where it really comes down to who a business owner is working with as far as advisors, because if a business owner is being told, hey, in all likelihood, you're going to have to do a deal and you will not get all of your money on closing day so that you can get the highest possible price. You need to pick the buyer that is going to have the greatest chance of being successful and is maybe the most coachable and the most open to, you know, accepting your feedback, et cetera. And so the people that I've worked with over the years, I've said like, this is part of what you're going to do. And the name of this show is 21 Hats. When someone is selling the business, one of the hats they're going to be wearing is the banker hat, and they're going to have to underwrite that buyer and figure out, can I trust this person with the business? Are they going to be a good operator? Are they going to be able to do the things that have to be done? And when a seller realizes, hey, I now have to add this element to my decision-making process, if there's many different buyers, for example, then it might mean that the seller might actually choose to sell to someone maybe who's offering a little bit less, but maybe they were a manager in that industry with a competing company versus someone who's coming in brand new from outside the field who doesn't have that kind of experience. Because to Josh's point, you bring someone completely new into your business. Yeah. You know, there's a lot of risk there. I mean, there's a reason why banks want to know that a buyer has some kind of business experience that is applicable. And, you know, he called out private equity. You know, there's a lot of things being said about private equity. And from what I understand, you know, that means that they're good at convincing wealthy people to put money into a pot to go out and buy businesses. And so each of those private equity operators is going to have a very different skillset and experience and background, et cetera. And so it's hard to paint them all with one brush because obviously you're talking about very different outfits. But yeah, absolutely would become an element in the decision-making process for a seller.

Josh Patrick And you also have to remember, Loren, that the businesses I dealt with had 100 employees or less. Typically under $10 million in sales. So when you start getting into selling those businesses, often you're dealing with unsophisticated buyers that come along with that. In my, in my, when I was advising businesses, I would always say, let's first look at a strategic sale where you're going to sell to a competitor because you have a reasonably good chance that they know how to run your business. Since they're already in that industry. So they also gain a lot by getting rid of much of your overhead and costs because there's no longer duplicate costs.

Loren Feldman Josh, did you have a strategy for dealing with the situation where a seller you were advising was confronting the need to take an earnout and you didn't think it was a good idea? What do you

Josh Patrick Do? I've advised them not to sell to that person. You know, it's really, you know, I always played the role of not being an intermediary. I was an advisor to the seller. So whether the business sold or it didn't sell had absolutely no effect on my compensation. So I wasn't sitting there saying, well, I really need to get this business to close, otherwise I don't get paid. So if I thought the deal was a rotten deal or there was something wrong with, you know, for example, I'll ask buyers to give a personal guarantee and to throw their house in as a rule. And if they're not willing to do that, I don't think they're a qualified buyer.

Loren Feldman Gosh, it sounds like you're saying it's not that earnouts are bad, it's that bad earnouts are bad. It depends on how they're structured. What's the difference between a good situation and a bad situation?

Josh Patrick Well, a good situation is you've done really good due diligence. You have real confidence that the buyer actually knows how to sell your business. You have confidence the buyer knows how to deal with recessions, depressions, business downturns. And the first thing they're not going to look to is how to hold back money that you are are owed. There are tons of liars out there. In fact, when I was writing for you at the Times, Lauren, you may remember that I wrote several articles about the worst sales of all times where people ended up not only not getting paid, but having to pay a big fine to the state because they stayed on as an officer in the company. Now, I didn't advise that company. But I learned about it after the deal was done and she allowed me to write about it.

Loren Feldman Dave, how about you? If you're advising a seller and the seller is confronting a situation with an earnout that you're not comfortable with, what approach do you take?

Speaker B So I'm also not an intermediary and I work with people as an advisor. And, you know, one of the things that you have to keep in mind is the aspect of time. So most, and I largely deal in the Main Street and lower middle market space. So we're talking about businesses that have a cash flow to their owner, like an EBITDA or an SDE of under $1 million typically. And these businesses usually go up for sale for one of 5 kinds of personal reasons. It's burnout, boredom, and fatigue, divorce, poor health, the need to relocate, and finally retirement. And so most of those, 4 out of those 5 are not things that people plan for. And so people will be operating a business, they'll be making good money, they'll be enjoying it, and then something will happen and suddenly they realize, I can't continue to operate this business anymore. I need to move on to the next thing. And they've got to actually take action on that sale and find the buyer and have the deal happen before that motivation starts to erode the business. Because if they've got something in their personal life that's undermining their vision of the future, then it means that what they're doing in the business could start to suffer. Sales could go down, earnings could go down. As soon as you have a negative trend, then every buyer is going to assume that there's something really wrong in the business and it's going to continue to go downhill. And so it really depends on what your options are for exiting. If you happen to own a business that's in a high-demand category and there's a lot of buyers out there and they can have an easy time raising money, then you probably don't face these kinds of questions. But if you're in a business that has fewer buyers and you need to act quickly, then it really depends on who you can find that's willing to do a deal. And then you have to try to make the deal that works as quickly as you can.

Loren Feldman So you're saying you work harder to actually Figure out something that works as opposed to just walking away.

Speaker B Well, if most of the time people don't have the luxury, the people with the most luxury are the people that want to retire, because you can put off retirement for a year or two as you wait for the right scenario and the right buyer, et cetera. But if you're being motivated by illness or family breakdown or, you know, something else, then if you do not act quickly, then the value of the business starts to erode.

Loren Feldman Josh, you were starting to say something.

Josh Patrick Yeah, I was about to say, I agree 100% with that, is that with the exception of retirement, you might be under the gun where you're going to have to take a deal you didn't want to take, and you do the best you can with what you've got at that particular point. Dave and I worked in the same pond when I was advising people to sell businesses. And I was lucky. I almost never had anybody except for retirement. They wanted to move on. They wanted to do something else. And if they had to work an extra year, year and a half to get their business ready for sale, then that was it. And also you have to remember, most of the work I did was in value creation, not selling a business. We would get into selling the business, but it often would happen after we had worked for a couple of years, maybe 5 years, sometimes even 10 years on value creation to get the business to be in the most attractive place it could possibly be. And in my opinion, that's the best way to help a business owner sell their business, which is get it well before they want to sell.

Loren Feldman And then sometimes they decide they maybe don't want to sell.

Josh Patrick Well, that would often happen. I remember I have a great story where I was working with a relatively large business. They had, you know, $20 million in EBITDA, and the owner was really unhappy because he was working too hard. So we worked to get his team to be able to take over the business, and his EBITDA went up by 50%. And after about 3 years, I went into his office and said, Brian, okay, you've done everything you wanted to do. should we go out and look for an investment banker? And he looked at me like I was crazy and he said, are you out of your mind? I'm hardly working. I'm making twice as much money or 50% more money than I was making before. Why would anybody want to sell this business?

Loren Feldman That's a good outcome.

Josh Patrick That was a great outcome. But, you know, it happens, I believe, more and more if a business owner has the brains, to really get their business to be sale-ready well before it's sold. They have a lot of options that the first 4 that Dave talked about don't have.

Loren Feldman A lot of what we're talking about here comes down to the issue of there's inevitably going to be some risk that a business doesn't perform as well after a transaction as it did before. Who should bear that risk? Do you have a principled stand on that, buyer or seller, or is that just a matter to be negotiated just like the

Speaker B Well, it doesn't matter who you think should bear the risk. The buyer always has outsized risk because the seller usually owns the business in addition to a number of other assets. They've got their house, their RV, their boat, their cottage, you know, all the other stuff, their retirement accounts, et cetera. And they own the business and that's what they're selling. The buyers typically are taking all their savings. They're borrowing from family and friends or borrowing from the bank. you know, they're leveraging their house. They're putting all of this typically into this one deal to get into a highly leveraged small business, which is a high-risk asset. And it's got to work perfectly for at least 10 years so they can pay down that leverage. And, you know, Josh mentioned, you know, a buyer should put up their house as collateral on any kind of seller financing. And I sometimes will talk with buyers and they'll say, you know, should I agree to this? Because they'll get the same kind of demand. And I'll say, well, how much equity do you have in your house? Or, you know, if they're borrowing against their house to get part of their down payment on the business, you know, I'll say, how much equity is going to be left? You know, why not offer the house as collateral? There's, it's not worth anything. Right. And for a lot of these buyers, they're so committed to these deals by putting all their chips on the table that really the personal guarantees don't mean a whole lot. Because if things don't work out, they're probably going to take what other little resources they might have left and they're going to put that into the business as well to try to make things work. And it's really only after everything's been exhausted and they have no other choices that they actually default on a loan payment. And by that time, there's nothing left to go and pursue anyway.

Loren Feldman How often does it work for the seller to remain actively involved in the business? I would

Josh Patrick Say almost rarely, if ever. Literally every time I've had an owner stay on with the seller, they're gone within a year because, and again, for whatever reason, the deals I was working on were primarily through companies that they really, they had their ideas and what they wanted to do, And the selling owner had his ideas or her ideas on how the business should be run. And they would have a disagreement, which would be a nice way to put it. And the seller would say, you know, I like you, you're good, but we're not getting along, so maybe you should leave. And even if they have a 5-year employment agreement, I would often see Year 1, year 2, that happened in the employment agreement, get bought out.

Loren Feldman What's your experience with that, Dave?

Speaker B It's similar to Josh's, and I would have to say the only time I've seen sellers successfully stay for a prolonged period of time is if they stayed to take a role that was several steps below the ultimate leadership role. So I've seen businesses that had a manufacturing component, they were making something, where the seller stayed to be like the shop foreman. Or I remember one case in particular was like a glass business where they would sell glass for buildings, like windows and that kind of thing. And the seller stayed on to be the sales manager, but they weren't involved in the leadership stuff at all. And the buyers enjoyed having them available if they wanted to run ideas past them or ask them about things that happened in the past, then It was great to have that resource there, but I, exactly what Josh explained, I've seen that happen too. If the seller is too close to the top of the org chart.

Loren Feldman Josh, you said early on that your biggest problem with earnouts is that you turn the business over to somebody else, they don't run it as well, and the alleged earnout disappears. What are the best metrics in that situation? What should be used to judge How the business is performing?

Josh Patrick I would say EBITDA.

Loren Feldman And is it, does that favor the seller or the buyer, or is that—

Josh Patrick I don't think that favors either. It's just a fact of what the business is actually doing. Is the business making more money? Is the business making less money? I had a client that bought a window replacement company and he came from a Fortune 50 company, had an MBA, very smart guy, But if the seller who sold to him was on an earnout, he would've been woefully unhappy because it took the buyer, my client, 3 years to figure out how to run the business. So it got back to being profitable enough where an earnout could have happened. And I think that when someone comes in as a financial buyer, you know, that it's not strategic where it's not in the same industry. And they're doing what Dave says, they're using every last nickel they've got. Well, there's a huge risk there for the seller if there's an earnout or seller financing involved, just because industry knowledge is not, you know, most businesses are 80% the same, but that 20% could be the difference between staying in business or not staying in business. And it's easy to make wrong decisions or hire the wrong consultant or the wrong, all sorts of other stuff. And all of a sudden you find the business taking a nosedive and before you know it, you're in the death spiral.

Loren Feldman Dave, do you agree that EBITDA is the right metric to gauge?

Speaker B Well, small businesses are valued either on EBITDA or seller's discretionary earnings depending on the size of the business. And that is only the start though. that is always the first glance because ultimately a buyer has to do some kind of cash flow forecast to take into account the things that those 2 numbers don't account for, which is taxes, capital reinvestment, in the case of SDE, the seller's salary. So, you know, businesses, people like to say, oh, it sells for a certain multiple of these cash flows. But the reality is a buyer has to do a lot of work to make sure that the deal's going to work for them. depending on how they're financing it, et cetera, what the demands are going to be for their cash flow. And, you know, I'll give a little story just to compound on what Josh just shared. I was once selling a business, a building supply company that imported a certain kind of material and sold it to general contractors. And we had 3 different offers on it at the same time. One came from an accountant, One came from a guy who was leaving like middle management of a big company. And the third one came from a guy who grew up in a household where his father was a home building contractor and he had already gone off and built his own sales business in the sporting goods space. And the 3 different people made offers. And the guy who grew up in the contracting household with the sales business He made the lowest offer, but the seller chose him because all 3 of the offers required some degree of seller financing, and the seller thought that that was the candidate who was going to be most likely to succeed.

Loren Feldman Interesting. So if you're advising a seller and they get an offer of 70% cash at closing with a 30% earnout, what's the first question they should ask? What's the next step? Well,

Josh Patrick It depends how much due diligence you've done on the buyer.

Loren Feldman The issue is kind of what Dave was just referring to, assessing.

Josh Patrick Yeah. I have talked to, especially, this was especially true in the wealth management business. I have talked to lots of people in the wealth management business and I've asked them, you know, the questions, gee, have you talked to the buyer? And these were strategic sales, so it wasn't like they were taking the last dollar out of their pocket to buy. I said, are you asking for a personal guarantee? Well, they don't want to give me one. I said, okay, they don't want to give you one, then don't sell them the business. But I won't sell the business unless I do it without a personal guarantee. And a relatively high percentage of those deals, they failed because the buyer, 1 year, 2 years, 2 and a half years into the business, something went wrong. And of course they don't blame themselves. They blame the seller and they say, well, you didn't tell me the truth, so I'm going to stop paying you. And now you have a choice. You accept what you've got or you get into a legal fight. And most of these folks accepted what they got.

Loren Feldman Dave, how would you answer that question if a seller you're advising gets that 70%, 30% offer? What's the next step?

Speaker B Yeah. So this is the way to think about it. If you're being asked to accept some degree of seller financing, then you are making a loan to them. And so you should be thinking like a banker and you should be thinking about what information you want to have access to going forward to make sure you can keep an eye on the business. So that might be a monthly package with P&L, a balance sheet, AR/AP aging reports, all the stuff that you know that you need to keep an eye on the business. So if you see something that's slipping, You can pick up the phone and call the buyer and say, hey, I noticed this is happening. Did you notice that? Here's what it likely means. So you can provide some coaching. So if you're doing a seller note, you're a lender. If you're participating in an earnout, it means you have an interest in the success of the business. That's just like being a partner. It's like owning equity. So if I was being offered something where a person wanted me to participate in an earnout, one of the things I'd want to see is their business plan. What do you intend to do with the business? Show me the forecast. Show me how you're going to change the way we do things. Show me how you're going to achieve the growth that was going to provide for this earnout so that you can actually see whether or not it makes sense. I mean, the seller is the expert. You're going to know if what they're saying jives at all.

Josh Patrick Now, one thing that we've done, and again, this is on an internal transaction more than it is a third-party sale is we've had the selling owner vote the stock until they're paid off, which means that they, you know, they get regular reports and they do what Dave does. If the business is going in a negative direction, they get in there and talk. But if the buyer decides to be belligerent, the seller can take control of the company again. They won't own it, but they'll vote the stock.

Speaker B I had one case where I helped somebody sell a bar, a nightclub kind of place, and banks don't like to finance these kinds of businesses. So it was basically a down payment and seller financing, and the seller wanted this package of documents every month, as well as the reports from the computerized liquor dispensing system that they had. And about 6 months into the deal, The seller called the buyer and said, hey, you've got a bartender stealing. Here's how I know. Here's how you're going to catch him. And coached him through that process. And without that oversight from the seller, the guy would've been a year of losing money before he would've ever caught on.

Loren Feldman That's really interesting. All right, I got one last question for each of you. Correct me if I'm wrong on this, but my anecdotal sense is that More often than not, these kinds of transactions lead to some kind of disappointment— buyer's disappointment, seller's disappointment, or both. Do you agree with that? And if so, is there a reason for that and a way to avoid it? What does your experience tell you, Josh?

Josh Patrick The answer is yes. I mean, it happens and it doesn't happen. If the deal is structured properly and it's a good buyer and the buyer knows what they're doing, then there's not going to be a whole lot of disappointment. But if it's being sold to somebody who again is a financial buyer that's coming in from the outside, there's a high probability or a high possibility anyhow of either one or both sides being thoroughly disappointed And ending up in court. So it really comes down to how well have you structured the deal? And more importantly, and I think this goes to what Dave talked about a little bit earlier, is how good are your advisors? Don't use your CPA. Get somebody who really does this all the time. Somebody like Dave who really understands the whole ins and outs, and he hasn't had any Whether the deal closes, doesn't close, doesn't mean anything for his compensation. And he can give really great advice. I mean, the time I've spent with Dave, which hasn't been a lot of time, but he seems to be right at the very, very, very, very top of his class. And when hiring an advisor, it's hard to figure out who it is because all these guys talk a good talk.

Speaker B Oh, thanks, Josh.

Loren Feldman That wasn't the food fight I was expecting, but I would tend to agree. Dave, how do you answer that question? Do you agree that these kinds of transactions will end up in disappointment for either or both sides more often than not? And do you have an explanation for that?

Speaker B It's not been my experience. So because the buyer need, in most cases, needs the seller and the seller support for the transition, to learn how to run the business, then that buyer has an interest in having a positive relationship with the seller. And because the seller, if they're doing some kind of seller financing, because they need the buyer to be successful in order to collect all of their money, they also need to have a positive relationship with the buyer. And this is one of the reasons why seller financing is so critical to good deal-making, because you're creating a scenario of mutual dependence. Both parties need each other. And if both of them come into the deal being open and honest and trustworthy, and they come to an agreement, both of them may not get the deal they absolutely wanted. There might be some degree of disappointment. The buyer might think the price is too high. The seller might think the price is too low, et cetera. But then they work together and they do the transition. And if everything works out okay, then they should become friends. And there are a large number of people that I've worked with in the past who years after selling their business continue to stop by the business with trays full of coffee or stop in at Thanksgiving or Christmas to see how everyone's doing. And they stay in touch with the business and they're proud of what it's become. And the buyers invite the sellers to special events or retirement parties and things like this. And the cases where people really are disappointed, It almost always leads to, it always stems from the fact that one of the two were intentionally deceptive. Either the seller knew there were serious problems with the market, the business, or something, and didn't disclose it to the buyer who later found out that they basically had been defrauded or ripped off, or the buyer had made serious misrepresentations to the seller and was not able to do with the business what they claimed. And a lot of the times that has to do with being under-resourced. So a buyer comes in with all these plans, but it turns out they don't have the money to cover the things that they wanted to cover, and they immediately have to start draining resources out of the business to cover debt service or something. And they undermine their own position from the get-go. So that's been my experience when people, One or both of them come into it with some kind of dishonest angle. That's what leads to disappointment. When you've got 2 people that are straight shooters, you usually end up with a friendship.

Loren Feldman David C. Barnett helps people buy and sell businesses. Josh Patrick is a consultant whose latest project is called The Long Strange Trip, which explores major life transitions, including the sale of a business. And they both have their own podcasts and they're both excellent. Thank you both, Josh and Dave.

Josh Patrick Thanks, Lauren.

Speaker B Thanks, Lauren.