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Bridging the Price Gap

September 28th, 2012

When it comes to mergers and acquisitions, the non-valuation business terms (shares versus assets, who stays as the management team, and so on) are often relatively straight forward to determine and negotiate, but rarely is this the case with price negotiation. Buyers are often focused on past performance, paying sellers for what they have done. Sellers want to focus on the future and getting recognized for what they have done but also getting paid for what the business is going to do. Business milestones such as a new product line that is about to be launched or a new agreement that could significantly affect future results are examples of issues that may impact price negotiations.

Earn-outs are often used to bridge the gap between what the buyer is willing to pay today and what the seller believes they should be paid (for tomorrow). However, earn-outs are not as simple as they seem and need to be carefully considered, measured and agreed to. Some of the key risk factors in earn-outs are:

  • What are the milestones? Any milestone must be clearly defined in the definitive acquisition agreement. Common milestones are financially-related – revenue, gross margin, earnings, and so on, or customer-related such as customer retention or renewal post-acquisition. In either case, everything must be clearly defined – what is a customer, how do you calculate revenue, what expenses are included / excluded, and so on.
  • Is the buyer motivated to achieve the targets? Are there any actions the buyer must take to ensure the milestones are met? Does the buyer have to show an effort at achieving the results? All this must be laid out in the definitive agreement to protect the seller.
  • How easy is it to measure the actual results? Earn-outs become very difficult when the business or assets being purchased are becoming part of a larger entity post-acquisition. New overhead and inter-company transactions can result in the financial statements post-acquisition looking very different than pre-acquisition. Depending on the size and structure of the acquirer and the importance of the target, sometimes earn-outs are not the best solution.
  • Does the acquirer use the same accounting policies? Something as simple as the timing of revenue and expense recognition can mean the difference between meeting a milestone and not. It is important that sellers ask these questions before final agreement.

When you are involved in buying or selling a business, if you are not experienced in the area, an earn-out may seem like the best way to achieve your goal. But as they say the devil is in the details. Please contact us directly to discuss how Evans & Evans can assist you with your business transaction.