After an unprecedented run of increasing values for companies, the market has cooled considerably since the Fed began fighting inflation with interest rate hikes in 2022. It’s left many small business owners wondering about the true value of their companies — a particularly pressing problem for those seeking liquidity.
The market is still strong for excellent companies, but changes in interest rates and the structure of sales have forced buyers to become more creative.
One historically popular tool that has been coming back into vogue in these fluctuating markets is earnouts. Those of us who have worked in M&A markets for a long time saw earnouts being heavily used before the roaring markets of the post-pandemic era made them nearly obsolete. But they’re back, with good reason.
Earnouts are typically offered when sellers believe their asset is worth more than the buyer does, and they allow the buyer to pay that difference in the future based on specific goals being hit. This also serves the buyer, who benefits from the continued motivation and participation of the seller in the business.
As debt becomes more expensive and valuations trickier to agree upon, the earnout has become much more prevalent. According to PitchBook, the use of earnouts has increased in each of the last two years. This makes sense, and earnouts can be a win-win for buyers and sellers. But as with every aspect of a business sale, sellers must be cautious. Here are some tips for ensuring an earnout provision works well in your circumstance.
■ Consider what you want out of the business and your future involvement. If you’re keen to remain involved — something many sellers prefer — an earnout can increase your drive and allow for more financial and career incentives. Conversely, if you’re looking to wind down, an earnout might be delaying you from reaching personal goals, whether that’s retirement or another business.
■ Make sure you get a satisfactory price without the earnout. Earnouts must be earned and are not guaranteed, so determine how much of the sale price you want to hit your account now, and what you are willing to let be tied to achievement of specific future goals.
■ Look closely at the requirements of the earnout. Make sure goals are achievable and fair, and be certain that you understand the components of the calculation and how they are defined to avoid disputes in the future.
Earnouts are not without pitfalls. In addition to following the basic advice above, many sellers may feel that they cannot adequately control the metrics they’re required to meet. If investment in the business post-sale will take place, you need to agree how that will help future growth, even if it trades off on immediate earnings. The general point is to carefully consider every aspect of the earnout provision and ensure you’re confident about the company achieving it.
The upsides of an earnout are significant in cases where it suits the seller. It helps a sale get done in what is now a much more challenging environment, where your company performance might have some future uncertainty, and bank lending is much more difficult to access and considerably costlier. It also provides a way to stay meaningfully involved in a business, even without an ownership stake. For entrepreneurs who built a company, that is often particularly important. After growing your company for years, or even decades, be sure you get full and fair value. ●
Brad Roberts is Co-Chief Investment Officer of the Riverside Capital Appreciation Fund at The Riverside Company