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Earnouts in Mergers & Acquisitions (M&A) Explained - YouTube
Channel: Brett Cenkus
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Hi everyone this is Brett Cenkus the
right-brained business lawyer and a
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business consultant and this video is
a video about mastering M&A it's
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specifically about earnouts in the M&A
context or what I call getting paid
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later now I've talked and written about
different ways to get a purchase price
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obviously everyone knows what a purchase
price is in the M&A context when you
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sell a business the buyer pays for the
business that's the purchase price
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now the purchase price can come in different
forms it can be partly cash partly
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seller financing it could be in the form
of stock of the buyer of the business so
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now you have their paper they're a
public company hey that's great there
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might be a little bit of a lock-up
period where you can't sell that stuff
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but after that it's freely tradable it's
easy to be to realize cash on it if it's
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a private company who knows I have to
give you their paper their stock it may
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be a long time until you can find a buyer
for that or until that company goes
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public or gives you an opportunity to to
realize cash for those shares that's all
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about different forms of the same set
purchase price different ways you can
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receive the purchase price and they
carry pros and cons earn outs are more
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about variable purchase price so with
an earn out if the business performs
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in a certain manner hits certain metrics
in the hands of the buyer after the
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closing the buyer will pay the seller an
additional amount or or amounts
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depending on the structure so the
business literally earns the purchase
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price the business in the hands of the
buyer earns the purchase price for the
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seller or very commonly and we'll talk
more about this in a few moments the
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seller or seller's will go with the
business and they'll actually work the
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business continuing in their roles
continuing in their their their same
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positions for the buyer and actually
earn additional compensation post
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closing so the earnout is about again
a variable purchase price and it's a
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fundamentally about sharing risk
it's about aligning the incentives of
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the seller and helping the buyer absorb
and helping the buyer with some of the
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risk that comes with buying a business
because absolutely buying a business
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carries a lot of risk the data
is out there half of these are
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public company mergers and acquisitions
but fully half of them fail to realize
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positive shareholder value so buying a
business is risky and you might know
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everything about your business you might
even have the buyer might even be involved
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with you in some manner might be a
customer a supplier or something but
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they they still don't really know what
its gonna be like to buy your business
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so an earnout is a way to help them share
risk and from your perspective I know I
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know you want to be paid today everyone
does you want to be paid the maximum
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amount right now in cash yet that's not
always possible and so I think you
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should warm up to earn outs for two main
reasons one is it might allow you to
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receive more money right you should be
in a vacuum you shouldn't have the exact
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same purchase price if you were paid in
cash versus your expectation on an earnout
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that that's not a fair sharing of
risk you're taking some risk for the
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buyer you're helping stay committed and
show your commitment to the business
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post-closing you should have an
opportunity to earn more than you would
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otherwise right that's number one number
two is you simply may have to accept an
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earnout right to have any opportunity of
selling your business this is
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particularly true when the business
fundamentally carries the transfer of
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the business carries considerable risk
and that might be the case because your
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you have significant customer concentration
right you kind of all in on one or two
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customers or the business clearly
operates around you you're really
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fundamental to it there's things that a
buyer is gonna be thinking look I might
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want that business but I it's just way
too risky if you aren't dialed in seller
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and if you're not working and helping me
realize value or if I lose that one
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big customer I'm in a lot of trouble as
a buyer so I might force you to take
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some of that risk and the market might
force you take some of that okay so
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let's say you get really good that an
earnout makes sense for you either have
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to deal with it or you decide hey I can make
more money this way be very very careful
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over earnouts where you're not going with the
business where you don't have control
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over the business post-closing so if you
sell to an individual right and you go
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sip cocktails on a beach while the
individual runs it the risk is quite
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simple you have no idea how that
individual will perform whether or not they'll
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treat the business like you did whether
or not they've got the ability to grow
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that business so there's a there's that
risk of who's performing it's not you if
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you sell to a larger business you have
that same risk but you have additional
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risks when you sell to a larger
business so they they already have
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product lines and service lines and
departments and divisions and all that
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stuff you're gonna be one more business
over there having a lack of control
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carries an additional risk not just that
they might not perform as well as you
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but that they might chop your business
up they might move part of it over here
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they might put someone in who's very
expensive they might this happens all
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the time and it's not for insidious
conspiratorial reasons the corporate
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might say look that division you know
your business in the hands of the
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corporate after closing needs to bear
some of this corporate overhead right
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everyone's paying some of the executive
salaries at the corporate level so
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they're going to push down operating
expenses that change the profit and loss
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of the business it might still be
growing the top line right the revenue
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but not growing the bottom line and so
on that point earnouts come in all sorts
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of different flavors but fundamentally
it's the business needs to achieve
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certain metrics so I've seen them I've
worked on them where you have to have a
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certain amount of customer attention a
certain amount of employee retention
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certain amount of revenue retention
certain amount of revenue growth certain
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amount of EBITDA which is earnings
before interest taxes depreciation and
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amortization it's a measure of profit
so you could come up with any of these
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things but if you do the bottom line
EBITDA or earnings net income than any
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corporate overhead that's being pushed
in there right in the corporation's take
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it from another division right the
overall parent company and putting it in
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this division the business you've sold
to them and that's going to lower the
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bottom line reduce the profits and that
might be just fine for them but it's not
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just fine for you so earnouts work best
if you go with the business if you're
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going to continue to run it then you
want to be very careful to negotiate as
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much as you can in the purchase
agreement about how that earnouts
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gonna work that you have control
over the profit and loss statement that
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any corporate overhead is limited to a
certain amount of corporate overhead
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they shouldn't be pushing in new
expenses and things like that you could
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talk about things like acceleration so
you would want to ideally an employment
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contract the earnouts two years
which is pretty common three years
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sometimes more than that it's fairly
rare so in a two-year earnout you would
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want a firm employment agreement which
you don't see employment agreements a
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lot in in private companies but you
would negotiate for one that says you
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can't let me go Mr. Buyer or Mrs. Buyer
unless you know you pay me out for the
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earnout unless it's for cause or certain
other things that you know they would
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have a right to let you go but otherwise
you wanna have control you want to have
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certainty that you'll be there you want
to have some protections that the parent
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isn't going to push other expenses down
there that they won't make decisions on
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your behalf for how the business should
run that affect you bid successful
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getting provisions that say things like
to the extent buyer takes an action that
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should reasonably be deemed as impeding
the ability of the seller to earn the
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earnout earnouts owed so you want to
kind of get in the weeds and figure out okay
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this is great I'm selling my business I
have a chance to earn more money that all
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works for me the devil's in the details
on those earnout provisions to make
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sure that you've got the control you
need that the buyers isn't playing games or
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just doing what they do to run the rest
of their business without a lot of
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concern about whether or not you hate
your metrics right so these things I'm
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talking about are way down in the weeds
but they're super super important don't gloss
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over them they're gonna be highly
negotiated right the buyer set will say
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we're buy we're buying the business it's
ours to run we can't agree to all those
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things but but they will sometimes so it
just depends and you want to negotiate
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as much as you can
again most buyers I'm not suggesting
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they're gonna be unfair but they're just
not as concerned with you as actually
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getting paid that earnout in fact they're
quite a bit less concerned they want the
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business to transition well which is why
earnouts work they align interest and
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share risk but they don't necessarily
need you to hit that particular metric
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for them to still define things as
success so you gotta get in the weeds on
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that stuff but warm up to earn outs
they're a great a great tool to align
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incentives might make your business
a lot more marketable if you've had
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problems with earnouts I'd love to
hear from you if you think they're the
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greatest thing ever I'd also like to
hear from you on that thank you for
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stopping by today
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