Businesses in some parts of the country remain difficult to sell in the current economy, even in an up market for auto dealerships. And negotiations between buyer and seller can be tenuous in any economic environment. Adding an earnout provision to a purchase agreement can smooth out a rough road and give the buyer extra incentive to “take the plunge.”
The provision is a promise
An earnout provision is contractual language that commits the buyer to make additional payments to the seller if the business achieves agreed-upon financial targets after the sale. Sometimes earnouts are called “payouts” or “contingent payments.”
Earnout arrangements can be the answer when the seller and the buyer disagree on the purchase price, and the seller believes, simply stated, that the business will do well. An earnout also can be useful when the buyer can’t come up with the full purchase price, and the deal will collapse without seller participation.
The seller accepts a lower payment, initially
In an earnout agreement, the seller typically accepts at closing a payment lower than the asking price and maintains an interest in the business. As mentioned, if the agreed-upon financial targets are met during a specified period, the seller will receive additional remuneration.
An earnout provision commonly seen in an auto dealer buy-sell agreement is based on new retail units sold. The buyer would pay a certain sum down at closing and would pay additional dollars quarterly based on the number of new retail units sold with a minimum guarantee. Some earnout provisions give the seller the right to claim company assets if the buyer fails to meet the payment schedule.
Both parties agree on financial targets
A crucial part of an earnout provision is developing the financial targets or milestones. As noted, these will entitle the seller to be paid the balance of the purchase price. Set targets carefully, making sure that your dealership’s new owner will likely achieve them.
The targets might involve gross sales or some other metric, such as the number of new and used retail units sold or gross profit percentages by department. Or a buyer might agree to pay the seller, for instance, 15% of annual earnings that exceed the previous year’s earnings by a certain amount. A CPA can help develop or assess ideal targets in an earnout arrangement.
Longer contracts increase risks
Three years is generally the longest term covered by an earnout provision. A longer period can subject the seller to greater risk, because it increases the possibility of adverse business events — for example, a new competitor, a consumer credit crunch or a major economic downturn — that are beyond the seller’s control.
If a longer period is sought, the seller could consider financing in the form of preferred stock in the dealership or a loan. Both of these alternatives give the seller recourse in case the business is mismanaged and the buyer can’t meet his or her financial obligations.
All risks should be identified
During the life of the agreement, various other factors might affect the buyer’s ability to meet financial targets. A keen understanding of every risk facing the dealership is essential to crafting the right targets and identifying the contingencies to attach to each.
To guard against adverse scenarios, both parties need to pinpoint any contingencies — the “what ifs” — that could affect the buyer’s ability to meet the financial targets.
Moreover, they must build in some protection measures so that the seller is adequately paid. Such measures include setting ceilings on the amount of capital expenditures allowed per year, and imposing restrictions on owner salary and compensation and dividend distributions.
Not for everyone
Adding an earnout provision to a purchase agreement isn’t appealing to all sellers. The valuation of your dealership business might give you the confidence to hold out for the selling price you want. But, if this might be an option for you, discuss it with your attorney and CPA before moving forward.