Earnouts - They Aren't All Bad

Earnouts & Clawbacks – They Aren’t All Bad For Sellers

How Property Management Owners Can Benefit From These Structures

I call it the E-word. Ask any small business owner if they’d be interested in a purchase structure that involves an earnout and you won’t get pretty looks. Somewhere between “no way” and “probably not” is a small space where sellers should spend some more time.

Earnouts are not always a bad option for property management business sellers. Especially when you consider they are an integral component in achieving a higher selling price for your company.

An earnout is a contingent future payment based on performance milestones. For example, in a simple earnout arrangement, an extra payment of $50,000 to the seller may be earned by growing the company by an additional $500,000 in revenue in the first 12 months after closing. A clawback is a contract provision where the seller must return a portion of the sale proceeds if future benchmarks are not met or relationships die off.

Earnouts become a sizable point of negotiation when there is a difference of opinion on what future earnings will look like. I’ve had many seller clients tell me they would never accept an earnout. Some sellers will dismiss any purchase offer that includes one, even strong offers from viable buyers.

On the other side, I’ve have many buyers say they’d never buy a company without an earnout in place.

In the sale of management companies I see earnout structures as fair, reasonable and sometimes, a lifesaver to a deal. They often bridge a divide that has no other solution.

Ours are service businesses with usually no tangible assets beyond office equipment. What we are selling is a reliable income stream. One built on the foundation of recurring revenue. The buyer is purchasing property management contracts, maintenance contracts, property owner relationships, brand identity, employees, vendor relationships, a host of other intangibles.

From the buyer’s perspective, there is a ton of risk involved. The buyer is banking on the hope that property owners, employees, vendors, marketing professionals and many others will all remain in place upon a change of ownership. As we’ve seen in many deals, that often does not happen.

This is where earnouts and clawbacks can help PM business buyers mitigate enough risk that they feel comfortable moving ahead and closing a transaction.

An earnout can not only make the seller more money in the purchase. It can also ensure that they actually get a deal done. That’s a huge argument in their favor.  

Here’s one tidbit I’ll share from my 15 years of brokering deals. You might be surprised how few negotiations break down or fail due to price differences. Sure, the price is critical. But all the deal points that wrap around trust, transferability, continuity, verifiability and scalability are typically what make or break a transaction.

How do earnouts come into play?

Earnout clauses are not typically used for companies selling for under $2 Million or $3 Million. Smaller businesses usually have much shorter transition periods, where the owner sticks around for 30-90 days and then makes his exit. Plus, most buyers want to come in, operate the company independently and in their own way, keeping the good while throwing out the bad. Smaller businesses often have unaudited books or poorly organized financials, which makes measurements for an earnout difficult.

The primary advantage of an earnout is how it bridges the pricing expectation gap between the buyer and seller. In some negotiations the earnout simply dissapears from discussions when both sides realize it will be too cumbersome.

They work best when the earnout period is not terribly long. In industries like manufacturing, IT, health care or medical supplies, you’ll commonly see earnouts last 18 months to 3 years or longer. The timeframe is usually tied to how long the outgoing seller remains active in the business.

In property management business deals, the timeframes are shorter, usually from 6 to 18 months. During this time the seller wants to retain some control to make sure the earnout targets are met. Most sellers resist having their earnout payments tied to company performance if they aren’t actively working there anymore.

The amount of the earnout can go anywhere from 5% to 50% of the sale price. Most common is a 10% or 20% earnout. In a $1 Million sale transaction, a 20% earnout means the seller will receive the last $200,000 over the given period.

The earnout can be tied to many different performance indicators, such as gross revenue, gross profit, net income, EBITDA, number of management contracts retained, number of new properties signed.    

We recommend to sellers the earnout be linked to revenue. It’s the cleanest and easiest number to guide from. Buyers often want to tie it to earnings since that’s what they care about, in the end. But sellers have tremendous fear they will lose control of the company, profits will slip and their earnout amounts will suffer.

Lawsuits are quite common when a post-closing dispute arises over earnings. So tie it to revenues whenever possible.

When Is An Earnout Warranted?

So how do you know if an earnout is justified when selling your property management business? Always remember what the investor is actually buying. They are buying a future income stream and everything that creates it. They are buying the future by looking back at the past and assessing the present.

If the company has stable revenues, consistent earnings, a large number of contracts in place and the owner is making modest and reasonable projections about future growth, then an earnout is likely not warranted. The buyer’s risk is low and so is the need for an earnout.

In cases where the company is experiencing good growth in revenues and earnings, sellers are apt to make highly optimistic projections for the future – and want to get paid for that growth. This is where inflated seller expectations can drive up asking prices and create more need for an earnout. If a seller is dead-set on achieving a certain price, earnouts are often the best way to get there.

In some cases, especially with the coronavirus impacting many businesses, earnouts are used as a means to “emergency-proof” a sale transaction. A buyer might use them as protection during economic downturns or if a company is experiencing difficulties.

In property management sales, discussions often revolve around the number of management contracts and whether they will remain in place after the business is sold. After all, property owner/clients don’t know the buyer or his/her people or his/her way of doing business.

So the earnout becomes a powerful incentive for the seller to make sure that relationships are continued smoothly, with as little interruption as possible. It also incentivizes the seller to work hard in transitioning the staff, software, maintenance functions and all major operations to the new company.

One Frustration I Have

 Some PM owners occasionally want to straddle both sides of the earnout fence. On one hand, they are completely opposed to earnouts or clawbacks in their purchase agreement. But on the other, they are making incredibly rosy projections about revenues and earnings for the next year or two. So their demands for a high price are based on earnings that haven’t happened yet.

In that scenario, without an earnout or clawback, a reasonable buyer does not see a way to reach that price or mitigate risk. It’s important for sellers to know that if they estimate enormous future growth, they’d better expect earnouts.

Clawbacks became more common in business sales following the financial crisis of 2008. They usually involve a repayment as well as a penalty. Property management buyers ask for clawbacks if they experience a high number of property owners not renewing their agreements. Or employees not staying on following the transition. Or vendors who don’t continue relationships.

Because relationships are so valuable to a property management company’s performance, clawbacks are sought by savvy buyers who understand the purchase risks.

Most sellers resist clawbacks whenever possible. The idea of giving back money is not attractive. However, clawbacks can become a useful instrument, like an earnout, in achieving a higher sale price. If the seller is able to get a number that would otherwise be out of reach, the possibility of repayment becomes a more manageable seller risk.

Earnouts and clawbacks can both become valuable assets to a property management seller who’s open to their benefits and who fully understands their risks. 

This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.