Disagreements over a business’s valuation aren’t uncommon.
If, for example, you want to sell your business, you may feel it is undervalued because of market conditions, so ou want to factor into your asking price the company’s future performance. A buyer may come along, however, who isn’t so sure that those future projections will be realized and hesitates when it comes to closing the sale.
That disagreement doesn’t have to be a deal breaker. You can bridge the gap of the two valuations by arranging an earn-out agreement, where you receive a partial payment with future specified amounts paid when the business meets certain goals.
For example: You set a sale price of $1 million based on projected sales for next year. The buyer feels those sales projections aren’t guaranteed. So you agree to take $500,000 on the spot and the remainder is paid out of, or adjusted to reflect, the income your business actually earns based on those projections.
You both benefit: The buyer gains an additional source of financing while minimizing risks and costs and you get to share in future earnings and, because the deal isn’t simply an installment plan, you gain some tax benefits.
But the agreement needs to be structured properly and address several issues, including:
- Duration: Earn-outs can typically run as long as five years. However, the longer the term the more difficult it can be to attribute performance to the business alone. On the other hand, you may face resistance to a short term if the buyer is concerned that a shorter duration could encourage you to make business decisions that favor short-term results but damage the long-term viability of the business. Moreover, to be able to get the benefits of using the cost recovery method when you pay your taxes, the Canada Revenue Agency (CRA) insists that the agreement last no longer than five years.
- Authority: You may want to draft an employment contract that specifies who has ultimate control over management and strategy. As the seller, you may want to retain control over operations to help ensure performance goals are met, over the sale or purchase of additional assets, and over the hiring of key staff members. Pay particular attention to the duration of the contract: the buyer may not be willing to maintain an employee role once the earn-out is paid.
- Performance goals: The agreement should outline such clear and achievable performance goals as sales, pre-tax earnings or gross profit as well as non-financial goals such as product or account development, capacity utilization, or service improvements.
- Performance evaluations: Clearly define the measurement base and be sure it is monitored. If the base is pre-tax earnings, you should ensure that the agreement specifies how one-time costs, unexpected costs, new management costs, transfer pricing and other costs or windfalls will be treated. Periodic audits can ensure that systems and operations aren’t manipulated to artificially boost or suppress performance measures.
Last Word: Any of these issues create the risk of litigation, so you should choose some method to resolve disputes and avoid litigation.
