You are sitting at a boardroom table in the office of your solicitor. Your accountant is to your right and your corporate finance partner sits to your left. Across from you is the buyer and their legal team. There are no spare seats.
You are about to sign your company away. An option is presented by the buyer’s legal adviser:
Do you want to take cash and shares and walk away, or stay for an earn-out over three years and have the potential to add £5 million to the pot?
What do you do? The signing pen is poised, and all eyes are on you. This is the awkward point you have been putting off for weeks.
What is an earn-out?
Think of this like selling your house or your car. There are two parties; you the seller, and the buyer with the cash. You want the maximum sales value you can get. The buyer wants a bargain.
There will be a cash or valuation gap between what you want, and what the buyer is prepared to pay. There are exceptions to this valuation gap which are explained later.
Imagine an example where you believe your business is worth £16m. The buyer's best offer is only £11m. To sweeten the deal, the buyer offers an earn-out which will pay an extra £5m in three years if the company exceeds ambitious profit targets. You have to remain as a paid employee and meet ‘good leaver’ terms.
In effect, the buyer is protecting their investment, so earn-outs are common. The message to you is the dangled carrot. If you and your company are as good as you claim, and ambitious targets are met, there will be another financial windfall on the horizon. After all, what’s three years between friends?
The benefits to the seller of an earn-out
- The seller gets a cash sum up front. This can be banked. It’s yours.
- You don’t suffer a sudden hard stop once your business is sold. You can phase yourself away. And you get a salary as a paid employee and are on site to stimulate company growth.
- There is the opportunity for another significant amount of money in the not too distant future.
- Some elements of the earn-out can be paid in stages, which may help with personal tax planning.
- The transition may be a great success and you might get paid earlier than the three years or get much more than the £5m.
- Suppliers and customer are reassured that you are still in the business.
The disadvantages to the seller
- You are locked-in for the entire period.
- The company isn’t yours anymore. You are a mere employee.
- Any major company decisions can be made without you. There is a real loss of control and influence.
- If you want out early it may invoke contractual ‘bad leaver’ penalty terms.
- You will be in limbo. Having banked your cash, you can’t begin your brand-new life adventure because you still need to go to work.
- The original employees may find it odd having the old CEO hanging around without much to do. Awkward.
- Your £5m deferred payment can be put in jeopardy by a host of events outside your control:
- The earn-out terms might be based on net profit, not turnover.
- Loose and woolly contractual agreements may come back and bite you.
- The buyer may load the business with overheads and liabilities. Group expenses are added to the P&L.
- Your top executive is transferred to another part of the buyer's group and takes talent with them.
- The buyer’s leadership team may prove incompetent in your sector and lose major contracts and revenue.
- The company may be relocated, leading to mass resignations and a dismantling of the talent pool.
- Your buyer could go bust, or failing that, miss some stage payments.
- Good customers are put off by your departure and take their business elsewhere.
- The buyer doesn’t invest enough to stay competitive and win new business.
- Your business buyer may be bought during your earn-out. Will your terms be met?
- Your business has been bought. The buyer may no longer have the motivation to help to hit your earn-out targets. Your mutual objectives are unaligned.
- When selling, it’s typical to sell to a larger business. They may not be nimble like your old business. Decisions can take ages.
- The business sector in which you operated, or the economy in general, may crash.
- You have short-term goals and the buyer has long-term goals.
How to sell your business for cash at full value
The magic ingredient (keep it a close secret) you need to have before any business sale negotiations begin is this…
Know your number
Understand exactly what your new post-sale life will look like. Have deep and lengthy discussions with your partner and family. Leave nothing undone. Work alongside a financial life manager who can map everything out for you and project this into your future. You are selling your business for cash but will have to pay tax. Factor it in.
You will lose all pay, dividends, and company perks. Add it all up. Calculate what your family running costs are, now and into the future. How much income do you need to live a good life without worry or debt? Again, don’t forget that income is taxed, and inflation is ever-present.
An experienced financial life manager and coach will help you calculate what for what amount you really need to sell your business. This is not what the market value is, or what an unknown buyer might pay. These factors are irrelevant to you and your family. Accountants, solicitors, and bankers will focus on core business metrics and spreadsheets. They are trying to value your business, but you need to value your life. These are two very different things.
Once you know your cash number, there are no negotiations or long debates. You can create the perfect business. Get great contracts with clients. Source the best executive team you can find. Work on the business, not in the business. Keep an attractive track record of growth. Offer fabulous products or services which people want and love. Neat, simple, elegant, and profitable.
Don’t tell anyone else what your number is. Keep it a closely guarded secret. In the example above, your personal ‘number’ might be £10m and not a penny more. This makes the negotiation easy. Take the £11m cash and walk away. The buyer will never know that they paid £1m too much.
Life is what happens to us while we are making other plans
Regardless of whether this famous quotation was from Allen Saunders or John Lennon, it is highly relevant to a business sale.
A client I worked with (and still do) sold their business for many millions of pounds, which was a life-changing amount of money even after tax. There was an earn-out for another £5m which was attractive enough at the time to stay for.
In this case the business venture was a success and the earn-out was paid in full.
Four years later we were having lunch together and the topic came up. The client told me that the three-year earn-out period was like a prison sentence. It was awful. Complete limbo. In fact, it led them to get professional therapy and treatment to cope with how it made them feel. The outcome was they would gladly pay all the £5m back to reclaim the three lost years. In their words…'What value can you place on a year of your life?'
Be very careful what you wish for.
If you are getting ready to sell your business and want to know your number, contact us to arrange a consultation with one of our specialists. It might be the best business decision you ever make.