Sellers Find Price Tied to Firm's Future Performance
 Earnouts, Seller-Financing Require Pre-Acquisition Checks

 By Dick Gregerson, President, Janas Associates.
Reprinted with permission from San Diego Business Journal
May 20, 2002.

Over the past two years, there has been an enormous change in the way in which businesses are purchased. The days of receiving stock and cash at closing are gone.

A weak stock market and restrictive lending practices now require many sellers to receive a substantial portion of their money at a future date. Sellers must evaluate the prospects of their old business under new management to reduce the risk of not receiving promised future payments.

It is now commonplace in the acquisition of small and middle-market businesses to find substantial seller financing and earnouts -- agreements in which a portion of the purchase price is contingent on company performance. The ability of the buyer to make these payments depends on the future success of the acquired business. Sellers can reduce their risk by closely evaluating the plans and prospects of their old company under new ownership, including a thorough understanding of its capital structure and expected performance goals.

The dot-com crash, the 9/11 tragedy and fears of a recession have made merger and acquisition transactions exponentially more complex. They often require a combination of cash, loans and contingent payments. It is not uncommon to have as much as 70 percent of the purchase paid out years after the closing.

Caveats For Transition Planning

Payments depend on the success of the company under new ownership. Some of the factors influencing that success are:

Quality of purchaser's management.  The track record of the purchaser in making acquisitions and the general business acumen of the management team will directly affect the retention of key employees, customers and vendors.

Transition plan.  A significant cause of poor acquisition performance is poor transition planning. A competent buyer should have a thorough transition plan that defines proposed changes, including the addition or subtraction of management and staff, integration of facilities, computer systems and accounting systems. Such a plan will reduce confusion, help retain key employees and preserve the business momentum.

Strategic Plan.  It is the rare new owner who does not want to make changes in the acquired business. Redirecting a company implies the risk of going after business the company may not get, or worse, business that alienates the current customer base. For example, if the seller manufactures professional, salon-only beauty-care products, and the buyer intends to sell them to drugstores instead, the move would alienate a significant portion of the business' existing salon customers.

Covenant and expectations.  Buyers make promises about the future performance of acquisitions to their investors, lenders and Board of Directors. Sellers need to ensure that the buyer has not made unrealistic promises that may affect the ability of the buyer to make future payments.

Why Acquirers Fail To Make Payments

Generally, acquirers fail to make payments for the following reasons:

Representations made by the seller about future prospects did not come to pass. In their zeal to get the highest price, sellers often present buyers with forecasts that are best case scenarios or "hockey stick forecasts," dependent on the miraculous turnaround of a declining business. Buyers rarely give much credibility to such forecasts, but often use them as an opportunity to create an earnout in which the seller only gets full price if the business actually achieves those unrealistic goals. With an overly optimistic forecast, the seller has in effect painted himself into a corner.

The buyer has mismanaged the business, and it is no longer performing according to its historical standards. Poor transition planning is the number one problem with change in ownership. In a recent Southern California acquisition, management waited so long to make up its mind on staffing changes that a substantial portion of the employees chose to leave. This led to very difficult financial times, and the buyer's inability to make payments as anticipated in the earnout agreement.

Unexpected loss of sales or increased expenses has lessened the value of the business. Most earnouts are based on the performance of the business over several years. A weak economy or the loss of a customer can reduce or cancel a portion of the earnout. Many earnouts are based on operating profits, with the seller assuming the risk of unexpected expenses. This requires a great deal of judgment when evaluating the adequacy of reserves and the allocation of expenses.

Dishonesty. Sellers need buyers who are competent, honest and honorable because they are relying on them not only to perform in business but to be highly principled and scrupulous when it comes to meeting the obligations of the contingent payment arrangement.

Where To Turn For Help

The vast majority of business sellers in California are private owners who have little experience with the problems and perils of buying and selling companies. Although a large number of business owners will eventually sell their business, they have never done it before and may be dangerously inexperienced.

Therefore, it is vitally important for sellers to arm themselves with a team of experienced accountants, attorneys and investment bankers. These seasoned professionals can ensure the success of the transaction of a lifetime. An investment banker can evaluate the buyer's financial capability, background and track record as well as examining the transition plan and the structure of the deal. An experienced accountant can analyze the purchaser's financial statements, and an attorney can draft a clear, loophole-free agreement.

Perhaps there will be another hot stock market within the next few years, or financial institutions will be eager to make loans on the premiums paid for acquisitions. But even then, the practice of contingent payments will probably remain an important part of selling businesses.

Buyers have recognized that such arrangements are a great way of bridging the gap between the buyer's and seller's opinion of what the business is worth. Pandora's box has been opened, and buyers are no longer willing to take all the risk.

Owners, who want to retire or sell for health or other personal reasons, have no choice but to share the risk. When properly planned and executed, the transaction can be beneficial to both parties.

Dick Gregerson is President of Janas Associates.