Vandenack Weaver Podcast

Listen to Evan and Nainesh on the Vandenack Weaver Podcast

Mary Vandenack, founder and managing partner at Vandenack Weaver, talks to Evan Levine and Nainesh Shah, partners at Complete Advisors LLC, about Earn Out Agreements and why COVID brought more attention to them. Listen in to learn the definition of an Earn Out Agreement, if they are uniform or specific, what type of payoff structures are available and the difference between diversifiable and non-diversifiable risk. If you want to know how to evaluate an Earn Out or if you should even use one, tune in to learn from these experts.

Mary Vandenack:             Welcome to today’s episode of Vandenack Weaver Legal Visionaries, a weekly podcast discussing updated legal news, evolving methods of providing legal service, and law practice issues. My name is Mary Vandenack, founder and managing partner at Vandenack Weaver, LLC. [00:00:30] I’ll be your host as we talk to experts from around the country about closely held business, tax, trust and estates, legal technology, law firm leadership, and wellbeing. Before we start today’s episode, I want to thank our sponsor. Here’s a message from Interactive Legal.

On today’s episode, my guests are Evan Levine and Nainesh Shah. Evan and Ninesh are both partners at Complete Advisors, LLC. Complete Advisors offers comprehensive financial services for business owners. In the business arena, services include valuation, enhancement, [00:02:00] and exit planning. On today’s episode, we are going to talk about earnout agreements. Thanks for joining me today.

Evan Levine:                      Oh, it’s great to be here.

Nainesh Shah:                   Thank you.

Evan Levine:                      Great to be here, Mary. Thank you so much.

Mary Vandenack:             So in its simplest form, what is an earnout agreement and why has COVID brought more attention to earnouts?

Evan Levine:                      So I guess I’ll… This is Evan. I’ll take this one first. I’m the simple child in the group. So [00:02:30] in its simplest form, an earnout agreement is contingent consideration in the sale of a business. So let’s say we have an 11 year old budding entrepreneur and she has a lemonade stand, and the lemonade stand consists of a table, a chair, some cups, some lemon, some sugar, a sign, a regular spot [00:03:00] that folks visit, and she also applied for a permit for this lemonade stand. A kid from down the block comes along and says, “I’ll offer you $100 for the whole business, the cups, the lemons, the spot, everything,” and the lemonade stand owner says, “Well, I’d be interested in selling it, but I don’t think it’s worth $100. I think it’s worth $300.” [00:03:30] Now fortunately, we have a clever attorney that lives in the neighborhood who overhears this conversation and walks over to the stand and says, “I’ve overheard you. I got an idea. Let’s do an earnout.” Here’s the deal. The buyer will give the seller a $100 lump sum payment, plus a stream of ongoing payments contingent upon certain metrics and milestones.

So perhaps [00:04:00] based on how many sales are made in the first year, or how many new customers are gained in the first 12 to 18 months. Maybe we could add a milestone. A payment will be made if the permit is approved, so forth and so on. That’s an earnout agreement in its simplest form. Second question was why has COVID brought more attention? Well, the earnouts have always been relevant in bringing buyers and sellers together when they’re too far apart on a price. [00:04:30] COVID has made it more relevant because they’re, in many cases, buyers and sellers are further apart than ever, because with COVID many businesses have had a downturn and perhaps the seller projects that when COVID passes, there’s going to be pent up demand and the business is going to shoot way up. Maybe the buyer thinks it’s never going to get back to where it was. So that’s why earnouts are more than ever in getting deals done.

Mary Vandenack:             Thank you. Anything you want to add to [00:05:00] that Nainesh?

Nainesh Shah:                   No, not really. I think in a basic sense it’s earnout is telling you how to get buyers and sellers together in a transaction.

Mary Vandenack:             So are earnout agreements uniform, or are they specific to each case?

Nainesh Shah:                   Yeah, let me take that. This is Nainesh. It’s [00:05:30] quite unique in each case because each transaction is unique, and if you think about what a buyer is buying and what a seller is selling, that kind of gives you the earnout criteria. As Evan mentioned earlier, when the buyers and sellers are far apart in the price, how do you bring them together? So think about, [00:06:00] say you are selling a biotech research company, or you are selling a existing old business which has a continuous revenue, or are you selling a technology company which needs implementation of some kind or are you dependent on key employee? Those are all the differences that happens when a buyer and seller come together, and then there’s a price difference, [00:06:30] that’s where they have to resolve. So each and every earnout case is different because of the underlying metrics are different, and on top of that the pay off structure is different, and we can go into more detail on each of this. But because of the complexity of different variables within earnout structure, it can be quite different from case to case.

Mary Vandenack:             See, you talked about the milestones. [00:07:00] Can you give me some examples of non-financial milestones?

Nainesh Shah:                   Yeah. So let me first of all define non-financial and financial milestones. Financial milestones are something that’s related to either revenue or EBITA or earning, or some combination of that. So anything that’s connected with financial changes of the company, that’s [00:07:30] more like a financial milestone. Non-financial milestone, on the other hand, are not directly connected with the financials. Although, as we know, that when buyer’s buying something, they’re really buying future earnings, right? But some of this milestone can be non-financial. I touched on a couple of them earlier. If you have a technology company and you have applied for a patent [00:08:00] and seller thinks that patent will come to through in next two years, but buyer doesn’t know. So that can be a milestone in a earnout, and buyer and seller can agree, say “If the patent comes through in next couple of years, then you will get an excess benefit back, but if it doesn’t then you don’t get anything.”

Similarly, if you have a… If you are in [00:08:30] a realistic business and building buildings, and there is a building that’s large going up, but it’s not complete. So the milestone can be finishing up that project. That can be a milestone. If you are implementing, if you’re a large company and if you’re implementing enterprise-wide software solution, but it’s not implemented, and this can be very risky, and that can be a milestone. So those are the different type [00:09:00] of non-financial milestone. The thing with the non-financial milestone, it’s usually pretty clean. So earning can be manipulated or changed, meaning if you increase expenses or you postpone some revenue, that earning is not clean, whereas non-financial milestones are quite clean in terms of either it happens or it doesn’t happen. If you’re going [00:09:30] to get a drug approval from FDA, either it happens or it doesn’t happen in certain timeframe, and so non-financial can be quite interesting for companies that are not fully developed.

Mary Vandenack:             And the FDA approval process is a whole interesting subject right now.

Nainesh Shah:                   I know.

Mary Vandenack:             So I just, I gave a presentation on Saturday related to the approvals of the various vaccines and their status. So thanks for that example. It gave me a good chuckle. We are [00:10:00] going to take a brief break from our episode for a word from one of our sponsors, Carson Private Client.

Mary Vandenack:             Okay, let’s continue our episode. Well, can we talk a little bit about typical payoff structures and how they are different?

Nainesh Shah:                   So there are many… Again, I think the core underlying thinking about are nowadays, how do you bring buyers and sellers together? And [00:11:30] the, so one way you can do that is defining the milestone or metrics that one uses. The other way you can bring that together is how do you pay once the milestone is reached. So, in a simplest form, it can be fixed, meaning every year you will get $10 million extra if certain things happen. [00:12:00] Great. That’s a fixed amount, and you’ll get it for three years. That’s it. Done, but it can be a percentage of a threshold, meaning if the revenue is a $100 million, but any revenue beyond that you’ll get 10%. So that’s a percentage of a total, but it has to cross the threshold of 100. Another way to think about it is [00:12:30] just plain, that you will get 1% of the revenue back. So that’s a linear to the underlying metrics.

Another way to think about payoff structure is there’s a threshold, and you get excess of that threshold, but then there’s a cap, meaning say you get 20 million is your cap beyond 100 million revenue of… And [00:13:00] you get 10%, but 20 million is a cap. So there are a lot of different ways you can design the payoff structure to either satisfy the seller or to satisfy the buyer. The flip side, which is exactly opposite of earnout, is clawback. If something doesn’t happen, can the buyer clawback some money that they already paid? That can be part of this structure as well. But [00:13:30] it’s a mirror image of the earnout.

Evan Levine:                      Yeah. Great Nainesh, and it just shows how much creativity advisors could bring to the table when helping bring the buyers and sellers together. It’s a fascinating topic and there’s endless ways to structure it, as Nainesh pointed out.

Nainesh Shah:                   Also, there are other complexity that gets added. It’s not just the payoff structure, but it’s a path dependency, meaning how this, a payoff, is going to get [00:14:00] paid. Are there multiple metrics that has to be reached? Are there multiple form of settlement? Meaning, is it just cash only, or is it cash in stocks? Is it, are there different currencies in more? Is it, are there, are the buyer and seller has some kind of a optionality at the end of the earnout period? There are so much complexity that’s get added [00:14:30] that people, the seller and the buyer. has to prethink all of this to get the best structure done. Otherwise, it creates more friction than not at the time of the earnout contribution.

Evan Levine:                      Yeah.

Mary Vandenack:             Which is-

Evan Levine:                      And they need a team of advisors to do it typically, and an attorney, a CPA, evaluation professional, financial advisor. That’s the key, is the advisors, and the advisors working in sync on behalf of the client or clients [00:15:00] to make it happen.

Mary Vandenack:             Well I have to tell you, because it is an extremely complex area that has a whole lot of factors. So I really liked the lemonade stand example at the start because I think that took a very complex topic and made it simple, and I assume you guys are probably familiar with the story of Shake Shack.

Evan Levine:                      Yeah.

Mary Vandenack:             It started at the little place in New York, and I always walked by and show everybody, “This is the original Shake Shack,” and so I’m thinking that’s almost, that’s what the lemonade [00:15:30] stand example made me think of, is some guy opened a little Shake Shack in, is it Madison Square Park? It’s one of the parks in New York, right?

Evan Levine:                      Yeah.

Nainesh Shah:                   Yeah.

Mary Vandenack:             And so you take that and turn that. It’s like, “Okay, we have this $100 lemonade stand,” and there is a lot of room for advisors and ideas, and so I really appreciate you guys sharing some of that, and so the-

Nainesh Shah:                   Yeah, and think about, Mary think about it now. If Shake Shack has to sell 200 location and they have another 15 in going [00:16:00] live, how do they structure that, right?

Mary Vandenack:             Right.

Nainesh Shah:                   Yeah.

Mary Vandenack:             When this was just the, I mean this was essentially, the Shake Shack was essentially the lemonade stand at one point, right?

Nainesh Shah:                   Yeah, exactly. Exactly.

Mary Vandenack:             Yeah, and so, and it happens to be a story I love because I used to go there before Shake Shack was public. But anyway, so can you guys speak to the difference between a diversifiable and a non-diversifiable risk in earnouts?

Nainesh Shah:                   Sure can.

Mary Vandenack:             Another easy topic. Can you make that into a lemonade [00:16:30] stand?

Nainesh Shah:                   I’ll make it as simple as possible, and Evan, add whatever you think.

Evan Levine:                      I get the s… I only get the simple ones. Sorry. Sorry. I told you I’m the simple child.

Mary Vandenack:             I love the simple example though. It was great.

Nainesh Shah:                   I know. That makes it easy.

Mary Vandenack:             And it kind of set us up for the more complex discussion.

Evan Levine:                      Yeah.

Nainesh Shah:                   So I think the diversifiable and non-diversifiable risk comes in from modern portfolio theory. In typical [00:17:00] financial model, you’ll see that if you diversify your holdings, your risk are limited to just systematic risk, and similarly, if someone wants to invest in earnouts, what they can do is invest in enough earnout streams so that they don’t have to depend on something that is diversifiable. So going [00:17:30] back to our original examples of different milestone or metrics, if you have a FDA approval, or a software that needs to be built, or implementation of some kind of project, or some building structure that needs to go up, all those are very specific risk, and if you have enough pool of the earnouts together, those can be diversified. But then you think about revenue, [00:18:00] or EBITA, or some of those financial metrics that we talked about, those are non-diversifiable because it is connected with the economy, and whatever happens to economy happens to financials in general of a company, and so that’s the kind of a background of diversifiable and non-diversifiable earnouts, and the reason to even think about this type of risk is how…

[00:18:30] If you need to value or not, what type of discount rate do you use? It will be different for diversifiable earnout pool compared to non-diversifiable earnout pool. The other risk that kind of is, I’ll quickly touch on, one is to be very clear that earnout can be quite… An expectation of risk and value of earnout can be quite different than the expectation [00:19:00] of the underlying metrics. Meaning, if the EBITA is expected to be 100 and earnout starts at 100 million, say EBITA is 100 million and earnout starts at 100 million, the earnout expectation can be a positive, whereas EBITA expectation can be zero, and I can go into more detail. But when you structure the earnout deal, when you try to understand the earnout deal, you have to make sure that you understand that underlying [00:19:30] business and the earnout of that business can have a different expectation.

Mary Vandenack:             So how do you evaluate in earnout?

Nainesh Shah:                   That’s [crosstalk 00:19:42]-

Mary Vandenack:             Another easy question?

Evan Levine:                      Yeah.

Nainesh Shah:                   There’s a million dollar question like that.

Mary Vandenack:             Or a 10 million or 20 million, or even more.

Nainesh Shah:                   Earnout needs to be valued for few reasons. Say a seller wants to [00:20:00] transfer their interest in earnout to some estate planning purpose, to a trust. That can be a reason for a earnout evaluation. It can be for a company who might just invest in earnout. That might be the reason for earnout evaluation, and in order to value earnout, you should think about what are you trying to really value. You’re trying to value some future expectation of that, or that stream [00:20:30] of earning that you want to receive, and the best way to value earnout is not market approach or asset approach. Asset approach is basically what you own in a business or a stream of earning. But there is nothing you really own other than the future expectation, right? And the market approach is pretty hard because there is no comparable. Market approach typically [00:21:00] is, going back to simplicity, if you are selling a house in a neighborhood, then all the other house that has sold in the neighborhood is your comparable.

Here, there is no comparable. There’s no real market data available. So the ideal way to value earnout is income approach, and basically what you’re trying to do is understand what is the expected cash flow, and then try to value that. There are two main [00:21:30] methods to value earnouts. One is option-based method, and second is scenario-based method, and if the earnout is… We talked about diversifiable risk, and so if earnout has a diversifiable risk and payoff is linear, then it’s typically beneficial to use scenario-based method, and if earnout is non-linear, it [00:22:00] has a non-linear payoff, and it’s non-diversifiable, then typically option-based analysis is better. But now we are going into a lot of complexity. We can definitely have another podcast and talk about all of these other scenarios. But that’s basically the way to think about earnout evaluation.

Mary Vandenack:             Yeah, and our goal today, really each of the questions that I’ve asked could be a whole podcast in and of itself, [00:22:30] right?

Evan Levine:                      Right.

Mary Vandenack:             So our goal today was just kind of give an introduction to some of those topics, and I hope we’ll follow up in some way on some more details to the extent of interest, and again, I think that we should have an article using the lemonade stand as the example though because that’s m… I was going to give you an example. So okay, if I’m… Well, I’m actually not kidding because I think that’s an easy one to understand and makes a complex topic simple. So thank you for that. It’s going to be my new favorite when I’m talking to clients. But so, before we get [00:23:00] to the end of today’s podcast, do either of you have any last thoughts or comments?

Evan Levine:                      Yes. So I have, again, a very simple observation, not… And you do, you can’t avoid the complexity and the detail, and that’s why we have an Nainesh. But when I started learning and trying to understand earnouts, it occurred to me how valuable it is, how valuable an earnout structure is, when the seller is staying on. So in the lemonade business example, [00:23:30] if the seller, if the buyer said, “Look, I want you to stay on for a year so you could introduce me to customers and show me the ropes,” and so forth and so on. “I’ll pay you a salary,” think about how helpful that earnout is to further incentivize the seller who’s staying on to really do a good job. So it, that’s a great, it’s another great benefit of an earnout, is incentivizing the seller who usually does stay on for, many times will stay on for a certain period of time.

Mary Vandenack:             And [00:24:00] often they want them to depending on the type of business, right?

Evan Levine:                      Oh yeah. Yeah, absolutely.

Nainesh Shah:                   Yeah, yeah. Absolutely.

Evan Levine:                      Absolutely. So there’s-

Nainesh Shah:                   Because going back to if you are buying a future expectation of some earning stream, you want to make sure that you’re going to see that, and usually the seller is a seller, or the owner of the business, can help make sure that you achieve that.

Evan Levine:                      Yeah. It’s an added carrot. So yeah, with at COVID and all the changes that we’re seeing, they’re, [00:24:30] earnouts are more relevant than ever today, and I’m sure you’ll be hearing more and more about them as, as we move forward.

Mary Vandenack:             Well thanks to both of you for being here today. Once again, I want to thank our sponsors, Interactive Legal and Carson Private Client. Thanks for listening to this week’s episode, and stay tuned for our weekly releases.