Earn outs and bonuses
June 07, 2023
by a searcher in Chicago, IL, USA
I am speaking with the seller of a medical related business and she is interested in staying on board and rolling equity into the deal.. She would also like an earn out over 3 years which she says will incentivize her to continue to grow the company. She would also like a bonus structure put in place for her and some of the key staff. The bonus would be a supplment to her salary once certain EBITDA and revenue targets are met and would be 5% of EBITDA (once she hits certain metrics). I am wondering whether the earn out and the bonus she is suggesting is the same thing? Does it sound like she is doubling up the profits by having an earn out and bonuses? Im not sure if I am thinking about it the right way. I would appreciate everyones thoughts. Just for clarity, the bonuses would be paid out annually, where as as the earn out would be paid after three years. Thank you.
from University of Pennsylvania in Reston, VA, USA
The setup seems quite reasonable to me, in that she will be wearing two hats: (1) seller, and (2) post-close operator; and she's asking for fair compensation in each role. Ask yourself if you'd pay a new manager the same compensation package if they knew the business and industry inside-out and had a track record of building a sellable company on top of the earnout that's in place for the seller. If the answer is "yes" then who cares if that manager you're paying just happens to be the same person who sold. Just be sure to stress "market rate compensation package" since she'll now be a professional manager and not the owner.
As you consider targets, remember it's easy for her to juice the revenue numbers by cutting prices (at the expense of margins). Since she'll be in control I'd be more focused on EBITDA targets than the revenue targets. Most earnouts I've seen focus on one or the other. The simpler the deal, the easier (and more likely) to get to close. EBITDA is a good target when the seller maintains control of the operations, again because it's easy to juice revenue by slashing prices. Similarly, sellers exiting the business often prefer to see their earnout payments based on revenue, simply because as a buyer it's never in your interest to let revenues fall, and if the buyer isn't a good enough operator to maintain margins, that doesn't hurt the seller.
The best advice I ever got from a pro was that searchers are often tempted to build complicated economic mechanisms. But the simpler it is, the more likely it gets to close. Good luck!
from Harvard University in Washington, DC, USA
Whatever you do - Earn out or IC - make sure that the metrics are over and above what you think you, as the buyer, will achieve with your team (without the seller's contributions). This should be for something NET NEW, IN ADDITION, that only the seller could make happen. The current business, and any normal follow on sales, renewals, etc - should all be the responsibility of the buyer and the team that came with the purchase.
Also - never pay up front for something that has not yet been booked. Too many times we see sellers embellishing the potential of a 'big deal' and that's just and entrepreneur talking like it's already a done deal. It's not. I get that sellers are enthusiastic and 'live in the future' and all that...but you are paying for hard cash flow. So only pay EO for IC AFTER a deal is penned and new cash flows in. Put a###-###-#### day accounting period on it and pay it in arrears, not forward.