The earnout provision: If negotiations stall, consider this…

The recent upsurge in dealership merger and acquisition activity in many parts of the country is expected to continue in 2015. If you think you may be a seller (or buyer) this year, it’s a good time to think about alternative deal structures that might ease the negotiation process.

One strategy to consider when sales negotiations falter is adding an earnout provision to the purchase agreement. This term of sale has been known to get the ball moving again when the seller and buyer can’t agree on price.

Jumpstarting the process

An earnout provision is contractual language that commits the buyer to pay a portion of the purchase price to the seller only if the business achieves agreed-upon financial targets after the sale. An earnout can be useful when the buyer can’t come up with the full purchase price, and the deal will collapse without seller participation.

In an earnout agreement, the seller typically accepts at closing a payment lower than the asking price and maintains an interest in the business. Some earnout provisions give the seller the right to claim company assets if the buyer fails to meet the payment schedule.

To illustrate, suppose that the seller of an auto dealership is firm with an asking price of $8.6 million based on projected sales. But the buyer can only come up with $7.5 million today between cash and bank financing. To close the gap between the seller’s asking price and the buyer’s offer price, the two parties could agree on an earnout provision whereby the seller will be paid $7.5 million at closing and receive payments totaling $1.1 million over the next three years. These payments would hinge on the dealership achieving, for instance, $45 million in gross sales for each of those years.

Setting financial milestones

A crucial part of an earnout provision is developing the financial targets. Set them carefully, making sure that your dealership’s new owner will likely achieve them.

The targets might involve gross sales, as in the example above, or some other metric, such as the number of new and used retail units sold, gross profit percentages by department or operating cash flow before owners compensation.

Guarding against risks

Three years is generally the longest term covered by an earnout provision. A longer period subjects the seller to greater risk, because it increases the possibility of adverse business events — for example, a new competitor or the loss of a key salesperson.

Other examples of risk: The new owner might decide to relocate the dealership or take on the costs of an expensive renovation project. Such changes could lower earnings or cash flow, causing the seller to lose out on one or more earnout payments.

To guard against this scenario, both parties need to identify any contingencies that could affect the buyer’s ability to meet the financial targets and build in some protective measures. Examples of these safeguards might include restrictions on owners compensation, dividend distributions, capital expenditures and rent increases per year.

If you base an earnout on an easily quantifiable financial target — such as gross sales or units sold — that isn’t affected by capital expenditures, owners compensation and other discretionary items, you’ll have fewer contingencies to worry about. Plus, the buyer will have fewer opportunities to understate the dealership’s financial performance.

Tread carefully

Before adding an earnout provision to your sales contract, make sure you’re comfortable with all aspects of the plan. Your CPA can help develop and monitor financial targets in an earnout arrangement, and analyze the risks inherent in the deal.