Bridging the Value Gap with Earn Out Provisions
Negotiations are crucial when it comes to sealing the deal and selling off your urgent care business to a willing buyer. However, it is not always guaranteed that the buyer is able or willing to pay the up front cost of your business; this is where the structure of an earn out provision comes into play for your deal.
According to Scott Soucy, partner at Anders CPAs and Advisors, earn outs are an attractive vehicle when there is a gap between the value that the buyer places on the business and the value that the seller places on the business.
“The seller wants to sell on next year’s projections, the buyer wants to buy on last year’s projections,” Soucy explains. “It’s typically used in companies that are experiencing very high growth rates.”
Peter Greenbaum, a partner at Wilentz, Goldman & Spitzer and an attorney that focuses in healthcare M&A and transactional law, further explains that an earn out is a mechanism by which the seller is compensated post-closing based upon the financial performance, or some other benchmark, of the acquired business.
“In the M&A field, it’s a way of compensating the seller based upon certain agreed upon post-closing financial indicators,” Greenbaum said.
Greenbaum goes on to explain that when these types of provisions are created, some of the reasons behind them include several aspects from both the buyer and seller perspectives.
“From the buyer’s perspective, it is often a critical component of a transaction. Instead of paying a fixed price, the parties will tie the overall consideration to the post closing financial performance of the business,” Greenbaum says. “It’s often a better indicator of the value of the business.”
Brian Berlandi, managing partner, Berlandi, Nussbaum & Reitzas LLP adds that an earn out is also the kind of gesture a seller makes for a buyer who might have difficulty getting traditional financing from a bank. Berlandi says that this is one of the benefits involved in the deal for the buyer.
“The seller may have a buyer who wants to buy the property, but the buyer is having trouble getting traditional financing. The seller doesn’t want that to kill the deal, so it offers to finance the property for the buyer to get the deal done. It’s usually not the first choice of a seller to do that, but if it doesn’t have a better option and wants to keep the deal intact, a seller will offer it,” Berlandi says. “For buyers, if you can’t get traditional financing, which will usually have better interest rates, you are still able to consummate the deal because the seller is financing it for you. It’s good for the seller and good for the buyer to keep the deal intact.”
Berlandi says one downside for the buyer is that you are going to pay more for that money. Meaning, the seller may agree to hold a note, but they may only hold it at 10 percent interest; whereas if a buyer goes to a traditional bank and gets a commercial loan that may be only around 5 percent interest; meaning that buyers will often pay more for the seller’s accommodations.
Greenbaum says that there are risks on both the seller and buyer ends of a deal.
“From the seller’s perspective, one of the bigger risks is the risk that the buyer, whether intentionally or unintentionally, changes the way that the business is conducted. That will negatively impact the earn out. If the buyer terminates critical employees or if the buyer mismanages the business, that then effects the earn out,” Greenbaum says. “From the buyer’s perspective, there is the inherent risk of the transaction of a loss of client or patient base. The earnout is meant to hedge against this risk, although cash paid at closing or not otherwise tied to the earn out is then at risk.”
Berlandi says that although there are some downsides, there are numerous benefits for both the buyer and the seller involved in these provisions.
“For the seller, instead of taking the entirety of the purchase price up front at the closing, it may prefer to have the benefit of debt service revenue spread out over time,” Berlandi says.
Soucy adds that every buyer and seller’s tax situation is different during these situations.
“Generally speaking, earn outs, if structured properly, are considered additional consideration of transaction, and they are taxed in the exact same manner as the original proceeds of the transaction. Typically that’s capital gain but that can vary based on how the transaction is structured and the unique circumstances of the buyer and the seller. Typically, there is no tax differential between proceeds received in an earn out versus proceeds received up front,” Soucy says.
Structure the Provision
When structuring an earn out provision, Greenbaum says the first key question is what you are tying the earn out provision to.
“In other words, an earn out is typically tied to some type of financial indicator of the business post-closing. Is that overall sales? Is that profit or EBITDA? Is there some other sort of benchmark such as the number of doctors that remain with the business,” he says.
The second issue to focus on when structuring a provision is to decide how long the actual earn out provision is going to last.
“Is it going to happen for a number of months? Is it going to happen for a year? Is it going to happen for some longer period of time?” Greenbaum says.
Greenbaum adds that from a seller’s perspective, you want to make sure that there are checks and balances and transparency in what is going on.
“A lot of times, the control will then pass entirely to the buyer in terms of how to control the business. From a seller’s perspective you want to know exactly what is going on and to be able to verify that what the buyer is telling you is in fact what is happening. This is because it ultimately affects how much ends up in your pocket,” he says.
Also, from a seller’s perspective you are reliant on the buyer to be able to continue the business, either in the ordinary course of business, or with that level of skill and competency that the seller had done pre-closing.
“From a seller’s perspective, they will want to make sure that they will have either input to the business for that period of time, or at least some type of handcuffs on the buyer that they can’t take the business and change the way that the business was run that would somehow negatively affect the earn out,” Greenbaum says, adding that obviously, federal and state healthcare regulations must be consulted when structuring the earn out.
Keeping the Buyer Honest
Berlandi says that there are ways the seller can attempt to ensure that the buyer will hold true to their aspect of the agreement.
“Because the seller is holding the note, oftentimes the seller is going to want security for that note, just like a bank would. So, the seller may require some collateral.”” Berlandi says.
According to Berlandi, the seller will often take a mortgage on the property like a bank would. However, Berlandi states that with these types of actions, there is the cost of preparing more documents, paying more taxes, as well as closing cost fees.
He adds that the strength of this strategy is that there is more on the hook for the buyer to follow through.
“For the buyer, if they don’t make the payments to the seller, they run the risk that the seller is going to foreclose and take the property back,” Berlandi says adding that every strength has it’s weakness.
“For the seller, if the buyer doesn’t pay, post-closing, they are going to have to go through the time and expense of foreclosing on the property and taking it back. Ultimately, the seller is once again in title to the property, which is exactly what it didn’t want and contrary to why it got into the deal in the first place. Most sellers don’t want to end up right back where they were in the first place.”
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.
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