An earnout in any transaction means a seller will not receive all the money he is due until certain financial components or targets are met. A seller’s price for their business is contingent on some performance metrics set by the purchase contract. There is usually some cash out to the seller at close in these deals, but a more significant portion of the purchase price is often contingent.
CPA or accounting practice transactions are the same as with most businesses. Historically, accounting firms are sold with 20%-30% down and an earnout. While this constantly evolves, deals are often structured with revenue or EBITDA targets that the ongoing concern must meet for the selling principals to reap the full price outlined in the definitive agreement.
Several factors should be considered before you agree to a deal like this. It will help the negotiation significantly and help you to understand the risks inherent in an earnout deal within the accounting and tax industries. Let’s look into those factors:
Any Earnout Adds Risk to a Transaction
Any cash not received at closing represents a risk to the seller. At this point, the risk may be perceived as small or large, but the fact remains that if it is not received in cash, it’s a risk.
The amount of risk is associated with several other factors:
- Is the principal sticking around during the transition?
- Do the employees have non-solicit or non-compete agreements signed?
- How much work is completed by the principal?
- How many relationships are tied to the principal?
- Does the book have a significant concentration of client revenue?
Earnout Deals Can Bring an Adverse Selection to Your Buyer Pool
An earnout in an accounting deal can bring the concept of adverse selection to your buyer pool. If you only ask for a small amount of cash at closing, many firms would qualify financially.
While this may increase the number of interested parties, it may also increase the number of buyers who are not adequately capitalized to take this practice on. This is “adverse selection.” Without realizing it, you have set yourself up to take on riskier buyers who either don’t have the cash to get into other deals or cannot qualify for bank financing.
All cash deals can also bring an adverse selection. Most savvy buyers understand that some downside protection should be attained in their acquisition. Historically there is a fall in revenue in the first two years after a sale. The best buyers may not even want to look at all cash sales because they understand the nuances of practice sales.
By setting the “right” terms, (cash out and amount and terms of holdback), you can strategically put both the buyer and the seller on the same page with regard to the transition and retention of clients.
Allowing a Large Earnout Can Open up “Cherry Picking” of Clients
A purchase agreement with low down and earnout components can open up buyer “cherry picking.” If a buyer only must pay for clients that stay with the company after the sale, a buyer can select only the best clients and run off the lower profit clients.
This is easily accomplished by providing superior service to profitable clients but failing to communicate or slowly servicing the low-profit clients. We do see this quite regularly in today’s environment, where capacity constraints and lower staffing levels impact the buying firms’ ability to service clients adequately.
This tactic is also used on stand-alone 1040 clients (individual returns not connected to a business or other business relationships). These clients are seen within the industry as lower revenue clients, lower profitability clients, and overall higher maintenance clients. A new buyer can run these clients off with large price increases or poor servicing and never have to pay for them if you allow a larger earnout.
Natural Attrition is a Real Problem in Aarnout Deals
Each year, an accounting firm experiences natural attrition of 5%-15%. Clients die, get divorced, move and change to new firms naturally each year. When the selling principal is still in their position, the firm receives new clients from referrals or advertising to offset this natural attrition.
However, once purchased, the buyer will believe that any new revenue should be theirs, not associated with the firm purchased. This item must be carefully negotiated if you are in an earnout deal.
You can do the math if you negotiate a 5-year earnout deal but have natural attrition of 10% per year. If natural attrition occurs, you are reducing your payout and have not negotiated “new business” to count in the earnout calculation.
Earnouts are Still Needed in Accounting Practice M&A Transactions
An earnout is still needed with most accounting firm sales. For buyers, there is no way to discover the strength of the retiring principal’s relationships with clients or potential client loss or protect you from revenue loss as a part of the attrition we see in CPA mergers and acquisitions.
For sellers, if you are expecting all cash, you may have an unsellable practice. The key for buyers and sellers is to assess any known risks of employee and client loss openly and to create a deal structure that puts both the seller and the buyer with a common goal within the earnout and retentive structure of the contract.
Both the buyer and the seller have risks. If these can be discussed openly and crafted into a definitive contract with action steps, it sets up the transition for success. The buyer and the seller can then work together to address employee and client retention issues. It simply sets the right tone for a deal, and when both the selling and buying principals work together, it is a fantastic message to the staff, who are often the primary client liaison.
If you are considering growth through acquisition as a buyer or considering exit as a seller, you should consider getting someone involved in the sale that has experience in mitigating the effects of retention and properly structured earnouts. There is a lot of money on the line in these earnouts, and obtaining proper consult will reduce risk, and maximize the benefits for both parties.
Berkshire Business Sales and Acquisitions has 15 years of experience helping buyers and sellers of CPA and accounting practices in Arizona negotiate the proper structure and the retentive variables. We would love to help you!