For a founder, owner or entrepreneur, the decision to sell your business is wrenching enough. You don’t need costly and aggravating drama after the sale closes. And yet, that’s what often happens to sellers, as buyers demand larger and longer earn-outs—where a seller must earn a share of the purchase price based on company’s future performance—and as other post-closing disputes increase in number and cost.
What follows is some information on this troubling trend and recommendations for avoiding post-closing disputes. I come to this issue having served as primary adviser to well over 250 middle-market business owners who have sold over the past 25 years, with combined deal value in the billions of dollars.
My experiences are backed up by data collected by SRS Acquiom, a firm that manages escrow accounts for hundreds of deals large and small. Based on the increasing level of contention between buyers and sellers it has witnessed, SRS shared the following observations:
- Earn-outs have grown to represent a far larger share of overall deal value, as buyers seek protection against future uncertainties. For instance, in 2013, the latest year for which data was compiled, the median of potential earn-out payments was equal to 46 percent of the payment actually made at closing. That’s a lot of your business’s value to wait for. As recently as 2010, the earn-out provision was half that size, or equal to 23 percent of actual payments at closing.
- And the wait has grown longer. The percentage of one-year earn-outs plunged from 20 percent in 2012 to just 7 percent in 2013. Half of earn-out agreements required that sellers wait more than two years for their money, SRS found.
- In a separate study, SRS revealed that in addition to earn-outs, other post-closing disputes are rising in number and potential cost to sellers. Looking at a sample of deals with $108 billion in total value and closings between 2010 and 2014, SRS reported that on top of earn-outs, there was $11 billion set aside at risk in escrow. And 60 percent of deals studied had at least one claim against the escrow account; of those, there was an average of 2.7 claims and buyers sought 24 percent of the amount escrowed. In 9 percent of deals, buyers sought at least half of escrowed funds.
- While studying earn-outs, SRS found that so-called financial buyers—such as private equity firms—are generally more likely to file claims and seek larger amounts.
How can business owners protect themselves against this trend? First, a few recommendations, no matter which kind of buyer you choose to sell to:
- Don’t kid yourself about your company’s value of prospects. Keep your own expectations reasonable, even if a buyer agrees to pay a price at the high end of your range.
- Most sale agreements will keep you running your company for some period, so don’t let up: Expect to work just as hard during an earn-out period as you did when building the business. You’ll need to retain key personnel to help your company perform.
- During the earn-out period, communicate with your buyers. Nobody likes surprises. Post-closing disputes of all kinds often arise when the buyer and seller haven’t been talking regularly and candidly.
- Expect trouble anyway, and don’t be emotional. Negotiate hard: Many post-closing disputes initiated by the buyer end up being decided in the seller’s favor.
My final advice for avoiding post-closing heartache is to choose your buyer wisely. As mentioned above, financial buyers are more prone to initiate disputes. And there’s one buyer category I believe is least likely to try to claw back money after a closing: your employees.
Beyond the tax benefits and increased productivity typically seen in employee stock ownership plans, or ESOPs, post-closing periods tend to have less drama. Some reasons for that include:
- If you sell only a portion of the company to employees through an ESOP and stay around to run it, there is no reason for sale proceeds to be held back.
- If you sell 100 percent of your company to an ESOP and finance part of the sale (take back paper) and stay around to run the company, that’s plenty of skin in the game going forward. ESOPs involve equity incentives for sellers that provide seller financing, often in the form of warrants.
- Should you sell 100 percent of your company and transition out of the business, any earn-out arrangement is from people you know well—you, your company and your team.
Mary Josephs, the former head of ESOP advisory at Bank of America, is founder and CEO of Verit Advisors, investment bankers specializing in ESOPs. You can reach her at CEO@verit.com.