Earnout structures with seller

January 11, 2021

by a searcher from Columbia University - Columbia Business School in Princeton, NJ, USA

I have a 12 month consulting agreement with the seller and 5 year non compete after. Are there any typical or recommended earnest structure to incentivize seller to hit revenue milestones or other metrics? What worked best for you? This is a light manufacturing business. Revenue growth have slowed to 6% from double digits. Plan is to increase higher margin business and resume double digit revenue growth.

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Reply by a searcher
from Baylor University in Chicago, IL, USA

I worked out another structure using a SBA, with an earn out based on EBITDA (we called it "Note Forgivability"). I will admit, the definition of "EBITDA" is going to complicate your deal. If you can stomach that, then proceed reading. This is how we structured it. Hope it helps bring some new possibilities to your structure:

Details and examples regarding Note Forgivability:

SBA prohibits “earnouts” or any sort of structure that provides for paying a seller more for a business after closing if the business hits any sort of metrics. Therefore, to make this deal SBA compliant, we need to do the reverse: we agree to pay the seller note unless the business fails to meet metrics.

Our proposal: Note forgivability + revenue stabilization period. This is more favorable to both parties since it gives a longer time horizon over which EBITDA must meet the hurdle before any amount of the note becomes forgiven. Here’s how it works.

Target EBITDA = $1.4M
Revenue Stabilization: At end of 12 months after Closing, actual TTM EBITDA is compared to Target EBITDA.
Meets or exceeds? Loan is paid off as agreed.
Fails to meet? Note on full standby for 12 months.

If full standby, then re-assess TTM EBITDA again in 12 months.
Meets or exceeds? Loan is paid off as agreed.
Fails to meet? Note on Full standby again for 12 months.

Note Forgiveness:
If full standby again, then re-assess TTM EBITDA final time at 36 months following close.
Meets or exceeds? Loan is paid off as agreed.
Fails to meet? Portion of note equivalent to difference x the multiple(pretend its a 4X multiple) is forgiven. Eg if TTM EBITDA at this stage is only $1.2M, then $###-###-#### = $200K x 4 = $800K of the note is forgiven.

Reply by a searcher
from Washington University in St. Louis in Denver, CO, USA

I would keep it as simple and straightforward as you can and do some combination of revenue and maybe one or two operational/activity-based KPIs that are easily measurable but still make sure the seller stays engaged and focused in the right places (e.g. if a medical practice, it could be hours billed to make sure their activity level is high during the transition period, and in your case you could even have the earnout relate in part/entirely to the higher margin revenue business to ensure that is where the seller is spending their time to facilitate that transition).

While in theory an EBITDA/profitability earnout may seem ideal on the surface, there are many challenges/headaches that can come up with this approach and it can get complicated quickly when it comes time to figure out how much earnout is due. I have seen debates around the timing of new critical hire(s) because of the impact of the salaries on the profit line as it relates to the earnout measurement period, and you can also find yourself and the seller debating accounting methodologies and things like payroll/vacation accruals, inventory reserves, costing methodologies, prepaids/general accrued expenses, etc. some of which are not black and white and all of which impact the EBITDA line and how much you will have to pay them. Keep it simple, easy to measure, and tied to the behaviors you want from the seller during the transition period.

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