Why buyers should give sellers a stake in the deal
by Everingham & Kerr
Business buyers can be so intent on achieving their own strategic objectives that they downplay or ignore possible roles sellers may play post-merger. That could be a mistake — or, at the very least, a missed opportunity.
Cooperative sellers, for example, can reduce a buyer’s integration workload by ensuring that functions, such as accounting, sales and IT, are ready to make the transition. Possibly more significant, a seller with a stake in the deal’s success will likely encourage key employees to remain with the business after the deal closes. The bottom line: When sellers are given financial incentives to help close and integrate a deal, its long-term prospects generally improve.
Most buyers incentivize sellers with a financial arrangement known as an “earnout.” Earnouts often are used to bridge price disputes between two parties or to finance part of the purchase price. The buyer agrees to pay part up front and the remaining amount after the companies have merged and certain conditions have been met.
To prevent sellers from getting the short end of the stick,
earnout agreements should be clear and carefully drafted.
When an earnout is used to encourage seller cooperation, the previous owner remains with the company in some capacity after the deal closes, often receiving weekly or monthly paychecks or consulting fees for their day-to-day involvement in the business. Transition periods of three to five years are common and owners are required to sign an employment agreement for that period.
At the end of the contractual period, the seller receives compensation in the form of stock options in the new company, the final installment on the business’s original sale price, additional consulting fees or a combination of these. To receive full payment, the selling owner must meet a previously determined set of objectives, such as:
The parties might project specific earnings or revenue growth targets over a three- to five-year period.
The buyer and seller determine that the merged organization should achieve overall or unit-by-unit cost savings.
Major objectives, such as improving market share by a certain percentage or successfully rolling out a new product, must be met.
Avoiding risks and complications
Earnouts offer obvious benefits for buyers, who don’t have to pay sellers unless the deal is successful. To prevent sellers from getting the short end of the stick, earnout agreements should be clear and carefully drafted to ensure that goals are reasonable and achievable.
Buyers who try to lard earnout agreements with an interlinked set of tasks — such as mandating specific customer retention levels along with hitting earnings benchmarks — risk alienating sellers and are likely to encounter pushback during deal negotiations. Buyers also should provide selling owners with some degree of flexibility. Contradicting or micromanaging the seller is likely to lead to conflict or possibly a lawsuit alleging that the buyer interfered with the seller’s efforts to achieve the earnout’s objectives.
At the same time, buyers risk giving sellers too much power and autonomy. If the selling company is financially troubled or has been healthy historically but has underperformed recently, it probably doesn’t make sense to pay an owner to continue running it.
Also, buyers with a strong, unified corporate culture may have trouble accommodating semi-independent entrepreneurs working in their midst. Sellers who stay on can slow down long-term integration because they’re unwilling to adapt to the new regime or because they retain the loyalty of former employees.
If you’re buying a company, you want the previous owner “in your corner” to some extent. A smooth integration and transition period may require an earnout structure to ensure both parties have a stake in the deal’s long-term success. But buyers also need to consider potential pitfalls. Will keeping the previous owner on staff actually benefit the merged company’s performance? Or is it simply a strategy to reduce the up-front purchase price? If the latter is true, ask your M&A advisor about other financial risk-mitigation strategies that don’t involve giving your acquisition’s former owner a stake in its future.
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