How to Structure and Value an Earnout Agreement

This video describes the structuring of a business earnout agreement and points the business owner may consider when preparing to sell their business and whether to include an earnout.

Speakers: Nainesh Shah, CFA, CVA, Evan Levine, ChFC and Martin M. Shenkman, Esq.

Transcript

Speaker 1 (00:06):
This conference will now be recorded.

Marty Shenkman (00:09):
Welcome to the program. My name is Marty Shenkman and I’m joined by two smart colleagues, Evan Levine, and Nainesh Shah. And we’re going to talk about a topic that’s really critical to business owners. I would even suggest not just looking for an exit strategy, but good information and knowledge to know. And yes, there’s our disclaimer. Everything is for educational purposes only. Don’t take any actions without consulting your professional advisors. So who wants us to explain to our audience what an earnout agreement is? And then I guess one of you is going to talk to us about selling lemonade.

Evan Levine (00:44):
Yeah. I’ll start with the lemonade stand Marty. Great to see you. It’s been a long time. So the lemonade analogy is as follows, for an earnout agreement. We have a 10-year-old entrepreneur that has a lemonade stand and another 10-year-old kid down the block comes to him and says, I want a buy your lemonade stand for a hundred dollars. And the seller says, no, I think it’s worth $300. So fortunately we have a clever attorney in the neighborhood who comes in and says, to get a deal done, let’s structure an earnout, an earnout agreement. The seller will give the buyer a hundred dollars plus, contingent consideration, which is an ongoing stream of payments based on predefined metrics and milestones.

Evan Levine (01:29):
So for example, based on a certain number of sales post-transaction, or based on a certain number of new customers post-transaction, or a milestone. Let’s say the lemonade standard is waiting for a local permit from the town. We could put in the contract if the permit is approved, there’ll be another payment. So essentially it’s a way to get a deal done when the buyer and seller are too far apart. Earnouts have always been relevant, but they’re even more relevant post-COVID when buyer and sellers are sometimes even further apart, because business is down and the seller thinks it’s going to come back, the buyer thinks it isn’t. So forth and so on. And that in its simplest form would be an earnout agreement.

Marty Shenkman (02:15):
What are the components Nainesh of a typical earnout?

Nainesh Shah (02:19):
Yes, Marty. So a note, first thing is you need to understand the metrics on [inaudible 00:02:26] milestone that you decide to create your earnout. So a milestone can be revenue number, it can be EBITDA number, it can be something similar. And these are all financials. But then there are a lot of non-financial milestones. It can be, if it is a drug company, is there FDA approval? If it is a construction project, finishing of a project. Or retention of a customer or retention of employee. Those are all can be incorporated on our agreement. And those are the metrics and milestones that you should be thinking about. You want to find the metrics that’s most ideal for you as a seller or most ideal for you as a buyer. Then you-

Marty Shenkman (03:06):
You let me interject a quick comment.

Nainesh Shah (03:08):
Yeah.

Marty Shenkman (03:08):
It’s really critical when you use structures that Nainesh just described, that the contract documents, the legal documents, are really precise and clear and have measurements and mechanisms to not only monitor, but to adjust if there’s an issue. And it’s critical for the attorney drafting these documents to understand the deal and the business to really draft them well. So be very careful not to shortcut those steps when you go on this path. I’m sorry, back to you.

Nainesh Shah (03:41):
No, no worries. And this is critical, Marty, because what you are trying to do is if you have earnout agreement for your business and you want to then value that to transfer for estate tax planning, that valuation gets driven because of what’s in the earnout agreement. So those metrics are critical in the valuation process.

Nainesh Shah (04:03):
The payoff structure is also a component of that. It can be linear, every quarter, every year you get regular payment. It can be some staff function. It can be part of related to the revenue. So if revenue goes above certain point, that can be ceiling, or that can be floor on the earnout’s earnings. And these are all part of the structure that you should be thinking about. And sometimes the payoff structures are part dependent. So for example, if you have a two year earnout agreement, but the limit is $20 million and you reach that in first year, then you don’t get anything for the second year. So the it’s a part dependent, but if you say only get 10 million in first year, then you still are open to get another 10 million based on the agreement for the second year. And that also is critical because, again, the valuation gets driven because of the path that it’s going to take.

Marty Shenkman (05:06):
And-

Nainesh Shah (05:06):
And lastly [crosstalk 00:05:07].

Marty Shenkman (05:06):
Settlement.

Nainesh Shah (05:08):
Yeah. So a settlement can be cash. Settlement can be some kind of a asset. Settlement can be of some other, different currency. Again, what you write in your agreement, as you mentioned Marty earlier, it’s critical. It will drive your total net value that you will receive. But in the end, how that value is represented in the valuation process is also critical here in the settlement.

Marty Shenkman (05:37):
Well, one last comment before we go to the next and last topic. You have to also be mindful what are your options if you’re the seller under an earnout. If you’re 75-years-old and looking to retire and sell your business, is it a viable option for you to recapture the business if milestones aren’t met or the agreement is violated? So you have to make sure that not only does the structure look good numerically, financially using some of the different mechanisms that Nainesh has has talked about, but you got to make sure that overall the concept makes sense for you.

Marty Shenkman (06:10):
Our next topic is to talk about how you value these methodologies.

Nainesh Shah (06:18):
Yeah.

Marty Shenkman (06:18):
Evan, Nainesh.

Nainesh Shah (06:20):
Yeah. So, as we were talking about earlier, you are creating an earnout agreement and now you need to think about how to value that agreement. Earnout agreement, the valuation is quite different than underlying asset. A business can have one value and an earnout on that business can be completely different. And this goes back to all the component that we talked about earlier, what are the different metrics that we are going to look at? How is the payout going to come out? What is the settlement method for that? If it is all financial related metrics, that’s a component of the earnout, and it can be one, or it can be two, or multiple financial metrics. The risk is nondiversifiable. And what I mean is, usually financial metrics are connected with economy. If economy goes up or economy goes down, those risks are connected with that. And it’s not diversifiable. But the nonfinancial metrics, for example, FDA approval or some technology implementation, or some construction project finishing. Those are diversifiable, in the broader sense. Although there are no real market for unknowns, but you can diversify in some sense. And so your risk calculation, which goes into the valuation of the earnout, depends on what type of metrics are used in that sense.

Marty Shenkman (07:55):
Any other comments before we wrap up Evan?

Evan Levine (07:58):
Yes-

Nainesh Shah (07:58):
No. So let me, before we go. I just want to mention that if the valuation, usually valuation involves income approach, market approach, and cost approach, and in our asset approach. In the case of earnout, it’s income approach is the best way to value, and depending on what are the components of the earnout scenario-based method can be used, which will look at what if situation or option-based pricing can be used. And that will give you the right evaluation of the earnout. Not more complicated than what we are talking about here, but this is just a framework that one should be thinking about.

Evan Levine (08:44):
And I just wanted to add before the valuation part and the structuring part, it’s useful in many scenarios, but it’s especially useful when the buyer is staying on, because now there’s more incentives and more skin in the game to make the business work.

Marty Shenkman (08:59):
So just an interesting thought, so very often from an estate planning perspective, when somebody gets an offer to sell their business, they rush to get an appraisal done, trying to see if they can get a transfer done for transfer tax, estate tax planning purposes before the business is actually sold. But interesting, I think when you’re that late in the game, it greatly increases the risk that you’re going to have to use the value from the deal, not some value from a hypothetical willing buyer, willing seller on an appraisal. But if you’re really getting an earnout for the business and not like a cash on the barrelhead, so to speak, payment, you still may have some very interesting positions to take when you discount the value of the earnout, when you measure the value of the earnout under the different types of scenarios that Evan and Nainesh have described. So it may actually be safer instead of trying to jump the gun and get something done before the transaction occurs to actually let the transaction occur if it’s happening in near time, and then use this type of analysis that’s been discussed to try to get a valuation that may be in fact less than what the earnout turns out to be. And that may be more supportable.

Marty Shenkman (10:15):
I want to thank Nainesh Shah and Evan Levine for their assistance, their email addresses are here. You can certainly contact them. Please, again, keep in mind that all these discussions on the entire website are for educational purposes only. Don’t take any legal action without consulting your advisors. Thank you for joining us.

Evan Levine (10:34):
Thank you Marty.

Nainesh Shah (10:34):
Thank you Marty.