Q: A potential buyer of my agency wants to pay most or even all of the purchase price as a percentage of my location’s net profit over the next three years. Our net profit has been very good this year, so I am tempted to go along with this formula, which could result in a high purchase price if we stay profitable. Are there any downsides to measuring the purchase price this way?
A: Selling prices that are based on percentages of future profits are full of risks. You need to add protections to the agreement that will control those risks.
By “profit” I mean revenue, such as commissions and fees, minus all expenses. If you have the Trams accounting system, the equivalent term is “total income.”
The most fundamental risk is that, after you sell, the expenses are in the buyer’s control. If sales remain good but the buyer increases existing kinds of expenses or adds new kinds of expenses, there could be no profit.
That is what happened to humorist Art Buchwald, who, for a profit percentage, sold to Paramount the story that became the hit movie “Coming to America,” starring Eddie Murphy and Arsenio Hall. Although the movie grossed $288 million, the studio claimed that there was no “profit” because “development” and “marketing” expenses were so high.
Buchwald had to file suit, but you can avoid litigation by making sure that your agreement has at least these four provisions:
- Provide that, during the three-year term of the earnout, the buyer cannot add to the income statement any categories of expenses that you did not have before closing, unless you consent to the addition. Examples would be overhead charges to support the buyer’s headquarters or management fees.
- If possible, provide that the buyer cannot increase any expenses, such as staff salaries, without your consent or at least without consulting you about the increase.
- Provide that each periodic earnout payment be accompanied by a very detailed statement so that the seller can clearly see what the expenses were.
- Provide that you have the right to audit expenses from time to time so that you can ensure that each cost is consistent with the agreement and pertains to your location or book of business.
Sharp readers have probably realized that these protections make the profit-based earnout very similar to the more typical revenue-based earnout. That is indeed the idea, as a revenue-based earnout is almost always preferable for a seller.
With both profit- and revenue-based earnouts, you need other protections, as well, including your terms of employment or consulting, a clear definition of the client base that the earnout will use for calculations and the kinds of revenue that will be included.
Ideally you should also have some limits on the buyer’s discretion to take steps such as closing the business or merging it with another buyer location or making other changes that could hurt revenue or profits, depending on the earnout formula.
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