The Missing Link For Valuing A Small Business - The Earnout - Part 1.

Have you ever seen the TV show Shark Tank?

It’s like Tinder for entrepreneurs, and its pushed straight into living rooms nationwide (so you can’t lie about what happened to family and friends).

Wacky wannabe entrepreneurs pitch their idea for a revolutionary new subscription based snake oil dispensary to the sharks - a panel of successful entrepreneurs turned angel investors.

If the sharks like what they hear, they try to justify how their existing network in the tech space is an invaluable asset when breaking into the burgeoning snake oil market. If they don’t like what they hear, it’s usually one word. “Next”.

After their 2-minute lightning pitch, the wannabe entrepreneur puts forward a valuation… $100,000 for 30% of the business.

The sharks furiously start scribbling in their notebooks. Applying a 3x earnings multiple to current snake oil subscription revenue of $0 per year, they come up with their own valuation.

$0.

Some lively negotiation ensues.

Most times, the entrepreneur is an ideas guy who hasn’t read the Ibisworld report on the snake oil market. They can’t regurgitate the numbers that the sharks want to hear and are promptly torn to shreds.

But sometimes there’s a match. A very smart entrepreneur with all the answers manages to survive the initial attack and earns the respect of the sharks.

They’ve also reneged on their initial valuation and agreed to sell 80% of their business to one lucky shark for $10,000, while also agreeing to quit their $200k a year job in marketing to focus on the snake oil biz full time.

Drama.

While Shark Tank has little relevance to business in the real world, it does rather dramatically emphasise one truth when it comes to buying and selling small businesses:

The ‘value gap’.

What is the 'value gap'?

The ‘value gap’ is the difference between the market value of the business (being what a buyer is presumably willing to pay) and the price that the business needs to be sold for, for the seller to be satisfied with the outcome. This might be what the seller would need to fund their retirement or perhaps their next business venture.

Buyers are wary of the things that could go wrong and price these risks into their offer:

  • What would the business be worth if a key employee were to fall ill and was unable to return to work?
  • Or if there was a change of management at a key customer?
  • Or if a key supplier went into liquidation?

On the other hand the seller invariably thinks that their business is fundamentally solid, and that the price on offer doesn’t take into account the numerous growth opportunities yet to be explored and economies of scale that can be achieved.

A method frequently used to deal with this value gap is by incorporating an earnout into the business sale agreement.

Why an earnout?

An earnout is a clause in the sale agreement providing for additional payments to the seller in the event that the business meets certain predefined performance targets.

For example, an upfront price of $1,000,000 may be coupled with an earnout right providing for an additional $300,000 at the end of year 1 where the company’s gross profit grows by 10%, or $500,000 where the company’s gross profit grows by 20%.

In this way, an earnout can work to align the interests of the buyer and the seller and allow the sale to go ahead.

An earnout can provide the buyer of the business with a level of insurance to ensure a smooth transition of relationships, key employees and business processes from the existing owners. It can also provide a positive cashflow impact by deferring part of the purchase consideration until the end of the earnout period.

Conversely, it provides the seller with an opportunity to prove to the buyer that there was indeed a basis behind their optimistic forecasts.

Earnout metrics

Some examples of earnout metrics include:

Financial

  • Revenue
  • Gross profit
  • Profit before tax
  • EBITDA (earnings before interest, tax, depreciation & amortisation)

Non-financial

  • Software development milestones
  • User growth
  • Renewal of key contracts
  • Regulatory approval being achieved

Understanding the strengths and weaknesses of each metric is important, especially once settlement has taken place and control of the business has passed to the buyer.

Financial metrics are the ‘staple’ earnout metrics, however, if poorly defined they can be manipulated by both buyers and sellers.

For example, revenue is one metric where the seller can generally exercise a high level of control post settlement, however this can incentivise the seller to push through unprofitable sales deals.

Profit before tax is preferred by buyers, but can be difficult for sellers to control. The buyer may change the business’ funding mix or start charging service fees from related companies, potentially inhibiting the seller's ability to meet the relevant targets.

Non-financial metrics can be useful in situations where the business is still in the startup phase and doesn’t have an established earnings history. However, meeting non-financial targets can be difficult where there is a lack of resources available post-settlement or the metric is outside of the seller’s hands altogether (for example, government approval).

Summary

While the Shark Tank is fun to watch, in the real world selling a small business isn't entertainment.

It’s helping a business owner unlock the retirement savings trapped in the business they’ve spent their entire life building.

It’s making sure that a prospective buyer who’s just taken a mortgage on their house to buy the business isn’t left with a basket case once the seller steps away.

Next time, when a wannabe entrepreneur puts forward their initial valuation, why don’t the sharks say “prove it”!

Stay tuned for part 2 of our series, where we take a look at the tax consequences to be aware of when considering whether to include an earnout as part of a business sale.

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It is important to remember that everyones situation is different. The information contained in this post should not be relied upon as specific professional advice. Please contact us to obtain specific advice in relation to your particular situation.

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