Q: The cover of the May 7 Travel Weekly had a short description of your column in that edition. It stated, "The best earnout formula for an agency sale factors in markups and back-end overrides." Would you say that this is true for most agency sales?
A: No; let me clarify. The best earnout formulas are actually those that avoid ambiguities and uncertainties that could lead to disputes and litigation. Including markups and overrides in the formula can be good only if they meet that criterion.
My May 7 column gave a few examples of areas that could lead to controversy: calculating hotel commissions, group expenses and allocating back-end overrides between buyer and seller. Let me take this opportunity to cover earnout problems in a more systematic way.
There are at least six potentially negotiable parts to every earnout: the percentages of revenue or sales, the definition or kinds of revenue or sales to which the percentages apply, the client base, the method or timing of recognition of revenue or sales, the measurement period of months or years and the frequency of payment.
A well-drafted formula takes all of these into consideration. Nevertheless, buyers often present formulas that cover just a couple of these elements, and the seller is forced to take it or leave it.
For example, an agreement may provide something like this: "Buyer shall pay 20% of revenue each month for two years after closing." If there are no further definitions or elaborations, such a simple sentence is an invitation to controversy.
In the travel agency business, there is no generally accepted definition of "revenue." Do the parties mean sales minus cost of sales, or do they mean the total of commissions, fees, overrides, markups, and GDS incentives? What about cooperative advertising payments by suppliers?
Many agencies post revenue as soon as they issue an invoice, but others do not count it until the check is received from a supplier.
Sometimes earnouts are even more imprecisely stated as percentages of commissions. In those cases, are service fees covered? What about markups? What about the cost of marketing to a group? What about GDS segment incentives and back-end overrides?
Sometimes earnouts are expressed as a percentage of sales, which can also lead to major controversies. What is the amount of a sale when there is a hotel or car booking that does not match up with any commission revenue because the client canceled or changed the booking on his own?
Just as importantly, the agreement needs to specify exactly which clients are included in the earnout calculations, which is the earnout element that I call the "client base." Is the client base just the clients listed in the agreement, all clients that the seller's staff brings in after closing or all clients who use the agency's location after the sale takes place?
What if the buyer closes the seller's location? What if the buyer adds new clients to the seller's location and feels that the seller does not deserve to be compensated on that business?
In most cases, the buyer's view on all of these issues prevails because buyers generally have more financial resources than sellers do. Retired sellers often do not have the money to mount a legal challenge, even if the buyer's position is clearly unfair.
It can take a lot of thought and drafting expertise to cover all these issues with sufficient specificity that almost every controversy can be avoided.