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Insights > 4 Steps to Structuring an Earn-Out Agreement: Part 2 – Company Growth Potential

4 Steps to Structuring an Earn-Out Agreement: Part 2 – Company Growth Potential

By Generational Equity

Investment Plant

Following the first part of our series on structuring earn-out agreements, which established how to choose the unit of measurement for your earn-out, our second piece now looks into the importance of knowing your company’s growth potential before you enter negotiations. While determining the right metrics forms the foundations of your deal structure, this is arguably the most important aspect in getting the full return when you exit your company.

Why is that? Because without an accurate estimate of your company’s current finances and what these will look like in the future, how will you be able to set realistic targets to fulfil your earn-out? Simply put, you can’t.

For those who missed part one, here is Axial’s definition of an earn-out agreement:

“With an earn-out, the buyer makes additional payments to the seller, after the sale, dependent on the performance of the business and the owner’s involvement in the business. Earn-outs are essential to closing deals when the buyer and seller just can’t agree on an exact price. They are designed to protect both parties and ensure that everyone receives fair value for the business.”

If a significant percentage of the agreed price for the business you have spent years nurturing is reliant on its performance post-sale, you can’t rely on guesswork when setting your expectations. While part one focused in on the importance of simplicity, here a comprehensive understanding is required to ensure you are set achievable targets post-acquisition.

Knowing Your Company’s Growth Potential

“In earn-out negotiations, understanding your business growth potential becomes the difference between realistic expectations and impractical expectations.”

How much is your company worth? And how much will it be worth in five years’ time? Buyers will want to know this information regardless of what structure your exit takes, as it shows them your business is worth investing in. As most entrepreneurs have around 90% of their personal wealth tied into the company they own, it is also important you have a clear idea about its true value and whether that will fulfil your financial goals.

In earn-out negotiations, this understanding of your business growth potential takes on another, vital meaning: it becomes the difference between realistic expectations and impractical expectations. If you project that your company’s annual revenue is estimated to increase from $3 million to $5 million in the next three years, you would not enter an arrangement where you need it to reach $7 million to receive the full price for your business.

So, how do you value a company? It starts by contacting a dedicated  M&A advisory firm, like the professionals at Generational Equity. Starting with an all-inclusive survey of your finances and analyzing your growth history, we provide accurate growth estimates on important measurements, such as top-line revenue, net income, and overhead expenses. Through this, buyers will not be in a position to underbid for your business, and you will be armed with the knowledge you need to approach an earn-out confident in achieving the targets set.

Don’t back yourself into a corner with your expectations like in the recent case of Vista Outdoors purchase of Jimmy Styks, LLC. The previous owners, facing a June deadline for this 2016 earn-out, planned to personally buy enough stickers between them to boost earnings past $2.5 million, triggering a $10 million stipulation. Unsurprisingly, this attempt to manipulate the numbers in this manner led to a court dispute in the favor of Vista Outdoors.

Lack of knowledge and over-confidence should be avoided from the outset to avoid setting goals which you cannot possibly reach. By taking the necessary time to apply all relevant valuation methods, establish what your growth potential is and discuss these with dependable advisors, you are far more likely to set realistic expectations and eliminate much of the risk associated with earn-out agreements.

Hopefully, you’re now confident about establishing a practical deal structure for an earn-out agreement, allowing you to be more flexible when organizing your business exit strategy. In part three, we will examine your role in an earn-out and getting clarity about where you will fit in your business post-acquisition.

Alternatively, if you can’t wait for the next part, you can learn everything you wanted to know about earn-out agreements at one of our informative executive conferences. Held throughout North America, these offer an invaluable insight into the M&A process, including techniques for business valuation, growing the value of your company, and exiting with assurances on you and your family’s financial future.

Please don’t hesitate to contact us for more information. We look forward to meeting you soon.

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