Don’t Pay Too Much for that Business -The Basics of Contingent Consideration

Have you ever worried that the business you’re purchasing won’t do as well as you’re hoping? Or what if there’s an outstanding debt you weren’t aware of? What if you’re over-paying? If you’re like most entrepreneurs, these thoughts have probably run through your head. At Davis Martindale, we can help you structure your business purchase to protect you from over-paying.

After years of building her widget manufacturing company into a successful business, Christine is finally ready to retire. The business earns $1 million in revenue each year, and Christine wants to sell the business for $1.2 million. David, a young ambitious entrepreneur, is ready to buy the business but has some concerns about its future performance. He has a couple basic options to help protect himself from overpaying for the business.

Earning those Earn-Outs

Right now, the business has $1 million in revenue each year. But what if Christine’s customers really like Christine – will the customers still remain if Christine is no longer their involved in the business? To protect himself from paying too much for a customer-base that might be ready to leave the business, David and Christine could arrange what’s known as an “earn-out” agreement. The basic structure of the earn-out could be:

• David will pay $950,000 for the practice, regardless of how it performs.
• In addition, David will pay an additional $250,000 if the business achieves revenues of $1 million in David’s first and second year.

By paying different amounts based on the future sales performance, David is protected from over-paying for the business.

Holding those Holdbacks

Christine has provided David with the balance sheet, so David knows what assets he is purchasing and what debts he is taking on. But what if Christine hasn’t disclosed all of the debts? What if there is a pending lawsuit that Christine hasn’t disclosed? To protect himself, David could arrange what’s known as a “holdback” agreement. The basic structure of the holdback could be:

• David will pay $1 million for the business, regardless of what issues could be uncovered.
• In addition, David will pay an additional $125,000 if no issues are uncovered in David’s first year.
• In addition, David will pay an additional $125,000 if no issues are uncovered in David’s second year.

By withholding some of the purchase price, David can be protected against unforeseen historical issues or issues caused by the vendor in his newly purchased business.

Non-Competition and Non-Solicitation

In order for David to arrange for either a holdback or an earn out agreement, he would typically also arrange either a non-competition agreement or a non-solicitation agreement.

A non-competition agreement would prevent Christine from competing with David’s business. The agreement would specify the period of time, geographic region and types of activities that Christine is prevented from competing within. A non-solicitation agreement does not prevent Christine from competing with David, but would prevent Christine from soliciting David’s customers and/or staff for a specific period of time.

At Davis Martindale, we never want our clients to over-pay for their business acquisition. If you’re considering purchasing a business, give us a call. We’d love to get you started on the right foot.