You want to sell a business but the potential buyer balks at the price.
How can you get closer?
First we must define the variable that we can adjust to provide a solution. A business buyer wants a price that both adequately justifies the risks involved with a business, and a price that outweighs the returns of an alternative purchase elsewhere. A business seller needs a price that both satisfies their reasons for selling, and outweighs the alternative of continued ownership.
The seller’s criteria can’t change, nor can the buyer’s alternative purchases. Of all of these criteria, the only variable that can be adjusted is the risk, and if the risk is lowered, the buyer can justify paying a higher price. It is for these reasons that earn-outs are becoming increasing popular.
Though earn-outs have their similarities to vendor finance, they are not necessarily designed to circumvent the issues with raising finance. More so, they are designed with two things in mind. The first; to reduce the risk to the purchaser by redistributing it between both purchaser and seller. The second; to allow the vendor to maximise the business’s sale price by carrying some of the risk themselves.
So how does it work? In instances where there is high uncertainty regarding the businesses future performance, business owner and buyer agree upon a reduced sales price under the proviso that the reduced amount be paid in full when certain conditions, usually relating to contracts or profits, are met.
An earn-out has the potential to take a risky business element that would have otherwise lost the sale or resulted in a substantial drop in asking price, and turns it into a bargaining chip.
For example, a business makes a $200,000 profit from a yearly contract which is now up for renewal. There is no assurance that it will be renewed so the buyer perceives this as a risk and asks for an equal reduction in the asking price. The owner knows that this contract will be renewed, refuses to drop the price and they come to a stalemate.
Generally, when a business is sold, all risks associated with the business are sold along with it. An earn-out dictates that the seller maintains some degree of risk after the sale. So in this instance the seller could agree to a $100,000 reduction in the
asking price on the provision that when the contract is renewed the remaining $100,000 be paid out by the buyer. So rather than force the buyer to swallow a $200,000 risk, both parties now share the risk equally.
The downside to an earn-out is that though the seller does not retain a share in the businesses, they are inevitably tied to the success of the new business owner. The situation proposed by an earn-out is a breeding ground for distrust so it is absolutely essential that both parties involved have their solicitors design an airtight contract with all bases covered. Earn- outs are complicated and time consuming, but if managed correctly can allow the buyer to mitigate risk, and the seller to maximise the selling value over an extended period of time.
Earn-outs are not for everybody. In today’s climate however, as the distance between the seller’s lowest price and the buyer’s top price becomes harder to reconcile, they are more frequently being utilised as solutions to otherwise unsolvable problems.
The main thing that should be taken from this is that there is always a way to get a business across the line. Negotiations should therefore be approached with a problem-solving and positive attitude. It’s a little extra time at the end, but in the scheme of things, if having the business change hands for the best price possible is the goal, it will definitely be worth it.
Disclaimer: All information in this article is for information purposes only. It should not be taken as financial, legal or any other advice. Individual circumstances of businesses and business owners may vary and they have not been taken into consideration. Always seek independent legal and financial advice for any matters regarding business sales.