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Reducing risk in earnout agency sale
20.11.2023 - 15:38 / travelweekly.com
Mark Pestronk
Q: I have found a buyer for my agency, and I have accepted an offer in principle where the buyer will pay me a percentage of the agency's revenue over the next three years (i.e., an "earnout"). I realize that anything can happen in the travel industry in that time and that I am taking a risk that revenue may decline and that the buyer may not even be able to pay me. What can I do to minimize those risks?
A: You could have your attorney try to put two kinds of protections into the agreement. The first kind is intended to limit the losses the business can suffer, and I call these "earnout protections." The second kind is intended to prevent default by the buyer, and I call these "default protections."
The first earnout protection is to try to set a floor on the amount that the buyer pays you, no matter how low revenue falls. At the end of the earnout period, the buyer would have to pay you, in one lump sum, the difference between the (lower) payments so far and the (higher) floor amount.
The second earnout protection is a set of limits on the buyer's discretion to make decisions that would have the effect of lowering revenue, even if the decisions would make the agency more profitable. For example, the buyer would agree not to close your office, not to fire any employees and not to change the agency name, phone numbers or email addresses.
In my experience, floors are fairly rare, whereas limits on the buyer's discretion are fairly common, but ideally you should try to get both.
For default protections, let me list them in order of the most common to the rarest.
- Be sure to try to provide for interest for missing payment deadlines. A buyer is more likely to pay on time if late payment costs more money.
- Try to get a personal guaranty from the buyer's owner or owners. If the buyer is a new company, try to get a guaranty by the parent company, as well.
- Try to get a right to repossess the agency in case of default. Even if you have no desire to run the agency again, the possibility that the buyer may lose the business is a deterrent to default.
- If the buyer has substantial assets, the agreement could provide that the buyer pledge his or her assets, such as real estate or even the buyer's own travel agency assets.
- Require the buyer to post a "standby letter of credit," which is a promise by a bank to pay in case the buyer defaults. The amount of the letter of credit would be the parties' present estimate of future payments.
- During closing, try to have the buyer place the estimated future installments in escrow with an escrow agent that will pay you if the buyer defaults. As with the letter of credit, this works only if the buyer has enough free cash as of closing to fund the escrow.
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