Ownership Transition in a Pandemic: Get Out with an Earn Out
Taking on ownership of an engineering or architecture firm can be risky, and the economic uncertainty from the pandemic has made it even scarier. But in spite of the uncertainties for you and the next generation of leaders, you don’t have to let COVID disrupt your retirement and ownership transition plans.
The problem is obvious: as a selling shareholder, you want to sell for a price that reflects the value of the firm you’ve built, probably over decades. Yet with so much uncertainty ahead, buyers may not want to take the risk of promising you that full payout, only to see the economy go south and the firm’s business dry up.
One solution is what’s known as an “earn out” – that is, to make the ultimate price you get contingent on the subsequent performance of the company. If the firm’s business proceeds as expected, sellers get the payout they expect. If it deteriorates, they forego some of their payout for the good of the firm. And if the firm’s performance takes off, they get to share in the wealth and receive a higher payout than they otherwise would.
To see how it works, imagine a firm with $15 million in net revenue and a 12% profit margin, with a valuation of $10 million. In a simple sale, the sellers would just get $10 million in cash, paid over a period of several years. With an earn out, those guaranteed payments might be reduced to $6 million, with an earnout that ranged from $0 if the company’s profits declined to $8 million if they accelerated. The sellers take some risk, but in this scenario they also have the opportunity to increase their payout by 40% if the company is highly successful.
From a buyer’s perspective, the earn out means less risk. In our industry, internal buyers usually have to take out loans, either from a bank or the company, to pay for their stock. If all goes well, the firm generates enough profits that the buyers can use their distributions to pay back the loans. But if the business runs into difficulty, the distributions dry up and the buyers have to pay the loan out of their own pockets, a burden which can be substantial. An earn out can ease some of the financial pressure by reducing the required payments if the firm is less profitable. On the flip side the earn out will attenuate some of the buyers’ windfall if the firm’s profits grow rapidly.
Earn outs have another advantage: they give the selling shareholders a strong financial incentive to help enable a smooth transition, transfer skills and client relationships to the new partners and be available for mentoring. While most selling shareholders are eager to do this anyway, a financial incentive always helps.
As an additional means of mitigating risk for both buyers and sellers in the near to medium-term, the parties may agree to an option to extend the purchase and sale period by one or more years. Think of this as the opportunity for a “mulligan year.” If performance one year lags – for instance if a firm’s normal base of clients is hurt by COVID-related delays – the parties may agree to simply suspend share payments that year and extend the term of the loan to give the firm time to recover. Payments resume with interest when performance normalizes.
Earn out provisions in buyouts may be useful in normal times, and they are regularly used in external sales with an asymmetry of information between buyers and sellers. They’re currently less common for internal transitions (likely due to the added complexity) but the benefits are undeniable, especially in uncertain times like the present. At Morrissey Goodale, we expect to see such provisions used more and more in the internal context.