Why Use an Earn-out?

Many times buyers and sellers cannot agree on a company’s value. The seller will usually point to strong growth trends, and the acquirer will emphasize the uncertainties and risk in the marketplace. If the seller’s representations about future growth and  revenue are correct, then the seller should reap the reward. However, if the company experiences a massive downturn in sales or if key employees leave after the acquisition, then the acquirer will have overpaid. Hence, the earn-out is a mechanism to share the risk so that the seller is rewarded if the company does well and the buyer can mitigate some of his/her risks if sales fail to materialize.  Earn-outs are particularly common for companies where success depends on a small group of key employees, where the assets acquired are a small portion of the transaction, or where the majority of the value is based on future growth.

Consider the following general information:

1. An individual who owns shares in a qualifying business corporation may be able to claim a $750,000 CGA when those shares are sold.  (It is not applicable to a business that is structured as a sole-proprietor).
2. There are two main rules:
   1. One regarding ownership of the shares, and
   2. One regarding the use of the assets of the corporation.
3. In the 24 months immediately preceding the sale and disposition of the shares, the shares must not have been owned by anyone other than the individual (or a related partnership).
4. The shares may be newly-issued and have not been owned for a full 24 months, but they must not have been owned by anyone else in that time.
5. In the 24 months before the disposition of the shares, more than 50% of the fair market value of the assets of the corporation must have been used principally in an active business carried on primarily in Canada.
6. At the time of disposition of the shares all or substantially all (90%) of the fair market value of the assets must have been used in the active business.  (Examples of non-qualifying assets would be stocks, bonds and rental property).

The other things to keep in mind are:  if the shares are sold to a non-resident of Canada or to a public corporation there could be a resulting denial of the capital gains exemption.  This is because the shares are now under the control of a purchaser which is not a qualifying small business

Franchise Agreement.  Is there a transfer fee involved?  Who pays?  What about training?  What is the cost?  Where does it take place?  Sometimes a new franchisee has to go away for two weeks to another part of the country.  Be absolutely clear on all the terms involved.

How do you deal and account for work in progress? This is part of the working capital that gets transferred over at the closing date when the sale of the business includes the operational balance sheet.  How this is accounted for and monitored is very important as it can be a substantial adjustment at closing.

Gift certificates.  How many are outstanding?  How do you monitor them as not all may be redeemed.  When are adjustments made and how will the new owner be compensated once he provides the goods (for which he has not received the payment) - it was a benefit the past owner enjoyed.  The costs are sometimes offset against (vendor) financing mechanisms.

Employee issues. When a new owner takes over a business with existing employees attention must be paid to the employees that are staying.  What obligations will the new owners have to them?  Holiday pay?  Bonuses?.  What happens if a new owner does not get on with the existing employees and decides to let them go?  New owner is obligated to pay for a period of notice.  Be careful about claims for unfair dismissal.

Today that view has changed and people now think of many healthy, active, productive years pursuing activities they love and making valuable contributions to society.  The truth is that if you really want to get the most out of retirement, you don’t really retire.  You simply shift gears and focus on different things. Also, at the end of the day, you must have a plan to deal with the challenges that life will present to you.  How will you deal with issues such as marriage, divorce, disability and death?  The problem for many people is not that events occur (they always will), but rather that they have failed to anticipate and prepare for them.  Events only become problems when they are not anticipated and planned for.  It is you and you alone who is accountable for ensuring that your plan does and what you want it to do.

Many of the common traps we see include:

• Not having any will or living trust.  Having an ill-prepared plan without competent advice.
• Titling too much property in joint tenancy.
• Failing to prepare and implement a business succession plan.
• Failing to plan for disability or critical illness.
• Emphasizing too much on taxation and financial returns without proper regard to asset protection and ensuring that your property will go to who you want, when you want and how you want.

How much money will I need?

For many people, the answer is to save as much as you can and hope that it is enough.

For others, they may have more than they could possible spend in ten lifetimes.  In all cases, however, the first and most important financial concern is ensuring that you and your spouse will have a guaranteed standard of living for as long as each of you shall live.  Therefore before you begin the process of planning the distribution or sharing of your wealth be absolutely certain that your lifestyle is guaranteed and that you and your spouse will be fully provided for to age 100.

The ideal is to create a flexible and dynamic plan while you are healthy and in control. However this is difficult to do alone you should seek out and retain competent advisors.  Tell them clearly what you want and listen to what they have to say.  Give this your full and complete attention, it is one of the most important decisions you will make.  Realize that there will likely be multiple aspects to your plan - legal, accounting, business sale, tax planning etc.  Do not make the mistake of thinking one advisor can completely handle all of this as in this day and age it is difficult to stay on top of one area let alone several.  However, remember at the end of the day you give the direction and leadership.  You hire and fire when required.  It is your plan you will be in charge but look to those people who are expert in their areas.

To get the best price possible a business owner should seek as many interested buyers as possible.  In business brokerage we say “one buyer is no buyers”.  The idea is to create competing interest and bids for the same business.  This not only compels people to move faster but it also quickly determines the seriousness of their intentions.  It gets rid of the time wasters.  It reduces the time to make decisions and get the transaction done, otherwise they can drag on for far too long.

There are also other reasons to use an intermediary:

1. A lot of the background work a business owner would have to do to sell their business is done for them.  We create a Confidential Business Profile that contains all the information a buyer needs to make an informed decision.  A business owner alone may not be sure what information to provide, he may also release sensitive information when it is not necessary.  (I saw one case when the “Buyer” was a rival company and was trying to find a list of the target company’s clients so that they could approach them directly and say “Hey, do you know XYZ Corp. is for sale - where do you plan on getting your “goods/services” from in the future?  We just happen to be in the same business”.  Very nasty).
2. As intermediaries that act for sellers and buyers we also constantly have interested buyers seeking acquisition targets.  We also know where the new buyers are.  We are able because of our training to look objectively at a business tell the owner what he needs to do in order to get the highest price and will go to work marketing the business to as many potential buyers as possible.
3. We also play another role very effectively.  We are able to take a very aggressive approach when negotiating.  We act as the “bad guy” or play dumb so that the relations between the owner and the purchaser always remain on good terms.  I don’t mind being the bad guy to get the owner a better deal.
4. We as business intermediaries act as a catalyst, in finding the buyers, in negotiating and in bringing a transaction to a close.  In business sales some very difficult issues will arise.  It can be costly and time consuming to have lawyers or accountants arguing about these issues.  As a result we often take on the role of mediator by looking at the problem from both sides.  This results in a compromise being reached faster and the transaction being more likely to complete.

As you can see there are many reasons to using an intermediary and at a minimum every business owner should at least have a conversation with one about the process of selling.

What makes a good Business Broker?  We really see our role as fourfold.  The first hat we wear is our “accountant’s” hat - every business must be understood, evaluated and priced in the context of prevailing market conditions.  The second role we play is as “salesmen” where we strive to create interest in our client companies (in a confidential way) and to let the market and synergistic know that a good profitable company is now up for sale.  The third hat is the “negotiator” wherein we bring two parties to an agreement relating to the transfer of ownership, financing and transition terms.  The final element is to be “intermediaries” ensuring that the transaction comes to a successful conclusion and managing the outside advisors that typically get involved at this stage.

I think the attributes that make a broker “good” are an understanding of the client’s personalities (both buyer and seller), creativity, intellect and forthrightness.  On a practical level a broker must also be licensed and qualified.  In the province of British Columbia an individual must be licensed under the Real Estate Act in order to buy and sell businesses on behalf of other individuals.  Often you will find real estate agents that normally specialize in selling residential homes will take on a listing for a business for sale.  This can be asking for trouble as it is outside of their realm of normal practice and they may not be qualified or capable of properly handling the transaction.  Pick a professional that focuses on selling businesses.  Every broker at our firm, for example, is a qualified realtor and is committed to ongoing educational courses put on by industry associations (like the International Business Brokers Association -  http://www.ibba.org/).  Finally, when looking for a broker to act on your behalf check out what their reputation is like.  Try and make sure you are dealing with someone who has high ethical standards.

On the other side of the coin, the Buyer oftentimes prefers an asset purchase as it is more straightforward from a liability standpoint.  When you buy a corporation you also buy that corporation’s liabilities, which means the due diligence has to be a lot more thorough (to ensure that you are not purchasing legal or tax liabilities for example).  Secondly, there are tax advantages to the Buyer by purchasing a business structured as an asset sale.  The Buyer can depreciate those assets, which assists in reducing his future tax burden.

In some cases, however, Sellers start with the intention of selling the shares of the corporation but circumstances require or force a change of mind.  One transaction we completed last year is a good example.  This was a five year old company that was in the business of designing and (wholesale) distribution of a range of home products. The owners wanted to sell the shares.  There was a fair amount of genuine buyer interest and in the end a synergistic competitor became very interested.  What this buyer however only really wanted was the inventory and the contracts (with suppliers and distributors).  They did not want the FF&E, the forklift, shelving, inventory monitoring software, warehouse space and obligations of the lease.  They were in the business - they already had all of this.

In this case, as I was acting for both parties (as a dual agent) I proposed a change to an asset purchase.  Why?  The buyers didn’t want anything apart from the inventory, the registered name and the contracts.  The sellers in the end sold their inventory at cost (no tax burden), and apportioned part of the purchase price to goodwill.  They kept control of a corporation which had over $200,000 in retained losses.  They were able to collapse their lease, sold their FF&E privately and maintained control of a corporation that one of the owner’s sons was able to use for another business venture.

In Canada the vast majority of the transactions we are involved are structured as share sale transactions.  In the US the story is very different where transactions under $1,000,000 are nearly always carried out as asset sales.  One reason perhaps being that corporate legal liability issues are just too worrisome and too potentially burdensome below the border.

In Canada, once we bring a Buyer and Seller together and an Offer to Purchase is executed by both parties, our clients will make use of their own legal counsel to “paper” the transaction, ensuring all liabilities are dealt with properly and in an orderly manner on change of corporate ownership.  On average this legal due diligence period typically takes about three to four weeks to complete.  A lot faster than many other countries, our associates in the UK, for example, plan for an average time period of six months to conclude due diligence.

As soon as we listed the company for sale we had a lot of interest, from individuals and from other tour operators. There is a good appetite for tourism businesses, for internet businesses and also for home based businesses. This trend continues today.

Within three months we had three very interested buyers. One group liked the business because it had a high percentage of repeat customers who in addition were high-end consumers prepared to pay more than average (but who of course also expected excellent service and product). The buyer believed he could up-sell other products and services to these clients. Another buyer group saw a lot of potential with a completely underutilized transportation element of the business. The third couldn’t believe the traffic that came to the website through organic searches and saw enormous potential in monetizing this.

Then one of the groups made an offer. After a few offers and counter offers the spirit of a deal was agreed upon and signed. Then began the process of due diligence, financial statements were reviewed, contracts were confirmed, the robustness of the software was checked, licenses were reviewed.

Then a hic-cup occurred. The buyer only had a portion of the purchase price and was seeking funding from a bank lender for the balance. The bank wanted “Review Engagement” financial statements as opposed to “Notice to Reader”. This would mean around $5,000 in accounting fees and a time delay of around six weeks. Who was going to pay for this? Why should the Seller pay for it as he didn’t need them and what if the deal collapsed? He would have a nicely presented set of books but what else? Also, the Buyer felt that he should not pay for it as if there was nothing to worry about and the numbers were a true reflection of the business then the deal would close. The result? Compromise. They agreed to split the costs. The numbers were confirmed. The bank was happy. Funds were advanced and the deal closed.

We always ask ourselves, what do we learn from each transaction? In this case we learned that every deal has unique triggers. These are features of the business that stand out and make it different from others, give it a key competitive advantage and make it attractive to Buyers. Not all Buyers see the same triggers but they are key in making a buyer move to make an offer. The other thing we learned is the need for parties to compromise. To be too stubborn can lead to a transaction collapsing. There has to be an element of give and take in these smaller transactions. Add to this the fact that oftentimes the seller and buyer will be spending the next few months together as the transition in ownership takes place. If the basis of the negotiation is too ruthless a lot of goodwill can be lost and may mean short-term financial gain for one party but can negatively impact on the longer term success and objectives of both parties.

Pricing a business is both a science and an art.  The valuation of a potential buyer and that of a seller or even an independent third party are very unlikely to be the same.  The reason for this is that there are no hard and fast rules that everyone adheres to when it comes to determining the price of a business (especially private businesses).

Profit is undeniably a great guide. Nevertheless there are many valuation guidelines applicable to different industries and sectors which can assist in giving additional “objective” valuations.  In many ways it all comes down to predicting the amount of money a business will make, valuing its assets or using an appropriate earnings multiple.

Discounted Cash Flow: In short this is based on the future cash flows of the business and is used for more established businesses with a consistent track record of earnings and profitability.

Asset based approaches:  If the business has a large tangible asset base (like plant and machinery used in manufacturing) then a valuation of its assets could be used.

Earnings Multiple: A valuation can be established by multiplying profits or free cash flow by the same earnings multiple which companies in the same sector have received.  Keep in mind some sectors are a lot more highly rated than others.

Many other factors will influence valuations and it is important to apply the right valuation model most suitable for the type of business in question.  Some businesses hardly have any assets, while others do not generate much cash.

The role played by intangibles should also not be underestimated.  The importance of valuable trained employees who are prepared to remain with the business, brands, licenses, contracts, relationships built up with customers are all important assets that have all to be fully understood by potential buyers.

Valuation of a business is absolutely necessary before any sort of sale negotiation can begin and the whole process should be conducted early.  Rather than doing this alone to get advice from experts is money well spent if it helps an owner realize the full value for the enterprise that they have built.

I live here in Vancouver and plan to cover a range of topics that are on people’s minds and as they relate to events, trends and also business opportunities. Comments and criticism, which are hopefully at least as interesting as anything I write, are welcome.

Owners of small and mid-sized companies thinking about selling their business are understandably concerned about current economic circumstances and the negative news heard daily. Some are putting their plans to retire or move on “on hold”. If sales and profitability are declining in their business, they fear this will impact negatively on the value of the business. Buyers, they feel, are also anxious what may happen to small businesses in the future and are therefore in the “driving seat” when it comes to negotiations.

However, other owners are still putting their businesses on the market and are receiving offers to purchase from qualified buyers at a fair price. Firstly, recent economic problems have not been so severe here in B.C. as in some other provinces and countries. Buyers are still out there and though values may have dropped it has really been those companies that were inflated to begin with, good businesses that were properly and realistically valued still have the same value today.

On a practical level there are always creative mechanisms that can be put in place to help facilitate a sale, like “earn out” options, whereby a buyer defers payments to the seller as revenues improve. Also, don’t forget, banks are still prepared to finance good business purchases based on historical cash flows.