Most people get a thrill out of buying a business whether it be to expand their existing empires or as a stand-alone operation. Thrills aside it’s an investment so like any other, whether real estate, shares or traditional business, it is never totally risk-free. That said, our experience says it’s unwise to be tentative and overly risk-averse. Instead, go for the business you want and offer to buy the business on ‘creative terms’.
So, you have finally settled on an online business you’re really interested in acquiring. You’ve done your due diligence, meticulously analysed the net profit figures, and thought through the rightness of the ‘fit’. It all seems good and you’re ready to go ahead. Now it’s a matter of negotiating and deal structuring. This is the most critical part. How many times have you seen institutional investments and acquisitions go wrong? Even the most seasoned make mistakes so while it’s a time for excitement it’s not a time to become overly emotionally-invested in the acquisition. Be crystal clear on the value you are placing on the business…this should be on the basis of its analysed profitability and potential.
Get to know the seller
Good negotiation produces a win-win settlement in which both you and the seller come away with what you need. Understanding what the seller wants, including the reasons for selling at the present time, the seller’s valuation and reasons underpinning it, and the payment timeline wanted by the seller, are all critical to your effective negotiation.
Building trust with the seller is vital. Assuming you are acquiring an established business with a record of profitability and on a growth trajectory (and, if not, why are you buying it?), then the seller will have authentic reasons for the sale which are important to understand. Assuming, also, that you are looking at a high six or seven-figure purchase price, then the way the deal is structured is vitally important to its success and you should go to the negotiating table fully understanding what you want to achieve.
For obvious reasons it will almost certainly be in your interests to negotiate only a partial up-front payment. It would be unusual for a seller to agree to a 40% delayed payment, but withholding up to 30% until an agreed final settlement date is common. This is technically a form of balloon payment ‘loan’ as the seller continues their equity investment during an agreed period, characteristically only a few months, during which the seller continues to provide expertise, advice and training. It also enables testing of external relationships and links on which the business depends and which are supposedly being transferred with the business.
The Earn-out Agreement
A more complex form of temporary ‘seller retained equity’ is an Earn-out agreement. For substantial businesses with a high six-figure or higher purchase price, this form of arrangement may be essential to negotiate. (Ongoing seller retained equity arrangements are different altogether and are used to enable a mutually desired continued involvement of the seller in the business over the long term.)
So, what is an Earn-out and how does it work? Essentially it involves a partial upfront payment at the time of transfer to the buyer. The proportion of upfront compared to delayed payment is subject to negotiation, but around 70% is a general guide. The remaining 30% is then paid in instalments according to negotiated performance criteria such as achieving the seller’s predicted milestones, or minimum monthly profit projections.
To illustrate with a simplified example. You have agreed to purchase an online business for $300,000, based on an audited net profit averaging $10,000 per month. In real terms the monthly profit figure could be seasonal rather than regular, and this would be factored in to the agreement. But for simplicity here let’s assume a regular monthly net profit. It has been agreed that the upfront settlement payment will be $210,000. The remaining $90,000 will be settled on the basis that each month $15,000 will be paid, but entirely contingent on achieving the projected $10,000 net profit in that month. There are any number of possible intricacies, such as no payment being made in a ‘shortfall month’ or more commonly payment on a sliding scale reflecting the percentage of the projected profit actually attained. This entails a higher repayment in a higher performance month.
This may sound complex, particularly if we factor in that the total purchase amount in this scenario could be finalised earlier or later than the approximately 6-months timeframe envisaged for the Earn-out period in the situation described above. In a nifty variation on this approach, some Earn-out agreements fix the time frame itself rather than the instalment amounts, with the effect that if the business fails to perform fully to expectations the final price paid is somewhat lower than initially envisaged and conversely if it performs better then the buyer finally pays a little more in total than initially anticipated. Few buyers would be concerned about this as it is a win-win situation all-round.
Given the complexity of the Earn-out detail to be negotiated, why do it? The advantages for the buyer are immense. Firstly, the obvious one of delaying full payment and the interest costs of investing 100% from settlement day. But more important is securing the self-interest of the seller in actively ensuring that all goes to plan, the projections are achieved or exceeded, and there is a smoothing of any potential bumps created in the transition process while migrating service provider accounts and supplier and client relationships.
While a six-figure or higher business acquisition will always involve a legally binding agreement, at the end of the day if there has been a 100% purchase payment made at the time of transfer then it will be close to impossible in practice to achieve compensation for any shortfall in predicted performance or for any unanticipated hurdles in migrating accounts. Retaining a proportion of the final payout figure provides real leverage to engage the interest of the seller in ensuring the smoothest transition. Leverage beats lawyers hands down.
Finally, honest relationships are the key to success. If the seller won’t agree to an Earn-out provision find out why. There may be a compelling reason for the seller’s position. If so, then that loss of leverage at the very least justifies you offering a somewhat lower purchase amount to offset the downside of settling in full at the time of transfer.
Negotiation needn’t be stressful. It’s a matter of understanding the seller, while remaining crystal clear about your own needs as a potential buyer.