This article first appeared in The Journal of Accountancy’s CPA Insider™ By Brannon Poe, CPA
Earnouts are popular deal structures used by buyers and sellers of accounting practices, but they have drawbacks. In an earnout, a buyer pays for a practice using the earnings that are actually experienced from that practice, plus an initial down payment in some cases. In a pure earnout structure, the buyer takes no risk in the deal and pays no interest, while the seller takes all of the risk.
One reason earnouts became popular is that many sellers (and many buyers) have difficulty imagining that clients will transfer easily to a buyer. They believe it takes months or years for clients to become comfortable with a new owner. As earnouts place a high level of risk on a seller, they keep him or her involved in the practice for a long time after a sale.
Our experience, however, has shown that keeping the seller involved isn’t the best way to ensure clients stay with a firm. A relationship cannot be handed off like a baton. The buyer has to develop his or her own relationship with clients. For this reason, we prefer to sell practices for 100% cash at closing. When this isn’t possible, we advise buyers and sellers to structure a deal that is a hybrid of an earnout and a cash-only deal. A number of variables can be tweaked to shift risk from one party to the other, such as the duration of the contingency period, the size of the down payment, and the percentage of price adjustment for each dollar of lost revenue.
In my opinion, pure earnouts place the risk on the wrong party, which is why sales with earnout structures lend themselves to problems. Here are some of the issues firms frequently run into when making deals that include earnouts:
Loss of clients. Earnout structures can lead buyers to “cherry pick” only the clients they deem worthy of keeping, because when buyers don’t lose money when clients leave, they have no financial incentive to hang on to those they don’t want to serve. This can be especially problematic when the buyer and seller have big differences in how they value clients and deliver and price their services, or when the buyer doesn’t have enough staff to give clients the level of service they’ve become accustomed to. Clients may become dissatisfied with the changes and leave the firm, costing the seller money.
My experience, as someone who has been involved in the sale of accounting practices since 2003, has shown me that buyers who pay cash for practices approach transition and client service with much greater enthusiasm. On the rare instances when buyers I’ve worked with have had earnout clauses in their contracts, those buyers typically lost a higher percentage of clients than did cash buyers. (One caveat: In some instances, earnouts really are necessary to protect the buyer. Most commonly, I’ve seen this occur when a practice has a concentration of especially large clients or when a past or present partner or employee may pose a competitive threat to the practice.)
More transition issues. Many CPAs believe that, after a practice changes hands, it’s good for the seller to stay in the office for several months to help ease clients’ transition. In my experience, that isn’t true. The earnout structure often incentivizes sellers to stay in the practice far longer than is necessary for a successful hand-off, and when that happens, control battles often ensue. Moreover, buyers often bond with clients faster if the seller is not around. If the seller is in the office when the client calls or comes by, the client will want to talk to the seller, not the buyer, and the buyer-client relationship is not nurtured. Plus, the buyer often loses money by paying the seller a substantial salary to stay on for a while. Often, the buyer could afford to lose a lot of clients for what he or she is paying the seller for extended transition assistance.
More disputes. When a seller doesn’t end up receiving what he or she had hoped for from the earnout structure, disputes often arise. According to data from SRS/Acquiom, in general business sales, two-thirds of earnout deals give rise to conflicts regarding escrowed funds. In my experience, the most frequent cause for dispute is that a buyer either didn’t calculate the revenue as agreed or was negligent in developing client relationships and/or providing reasonably good client service.
Why to choose a cash deal instead Cash deals happen much more frequently than CPAs realize. At our firm, we often sell practices for all cash or cash equivalent with no risk to the seller for client retention. Approximately half of our transactions are sold with 100% cash at closing, while approximately 90% of our transactions have fixed-price structures, leaving only about 10% with any contingencies whatsoever. We believe a small sacrifice in price is well worth getting the right terms. Furthermore, we believe fixed pricing helps both parties in the deal because it generally facilitates better transitions.
The biggest benefit of these no-contingencies deals is that they allow the seller to move on to retirement or to his or her next endeavor without worrying about the practice for years after the sale. The seller can experience a clean break—after all, the new owner of the business should be the one who has to worry about it. Cash deals also benefit the buyer because they allow him or her to make the decisions about how to best run the business. It’s the buyer’s to grow or change as he or she sees fit from day one.