Q: A larger agency wants to buy my agency and has sent us a purchase agreement to review. The purchase price is mostly an earnout; i.e., the installment payments are a percentage of the revenue that our office generates during the two years after closing. In the contract, the definition of "revenue" is very extensive: "'Revenue' shall mean base commissions on all modes of travel, including airlines, hotels, car rentals, cruises, tours and insurance; point-of-sale and back-end overrides, markups, service fees, transaction fees and GDS segment incentives; and any other kinds of travel business revenue, which is actually collected during the previous month." Is this a common formula? Do you see any problems with this extensive formula, and if so, what should we propose instead?
A: The majority of acquisitions today have earnout formulas, but few include elements such as markups and back-end overrides. So if you are going to have an earnout formula at all, this one is, at least in theory, better for you than most, because it covers those revenue elements.
However, in my experience, if sellers end up with less money than they anticipated, they can often dispute the buyer's accounting. If there is no resolution to a dispute, the parties can even end up in litigation over the earnout results.
Here are some common areas of dispute and ways to avoid them:
For larger sellers, there often seems to be an issue about hotel commission calculations. In principle, it should be easy to figure them out accurately because the standard commission is 10% of the sale.
However, in practice it is very difficult for large buyers to match batched payments from hotel commission aggregation companies that the major chains use on the one hand with each specific hotel bookings by the seller's location on the other hand. Car rentals present the same problem but to a lesser extent because so many rentals are noncommissionable.
One way to avoid controversy over hotel and car commissions is to exclude them from the earnout calculation, while raising the earnout percentage just a bit so that the total payments are approximately the same as they might have been if the formula had included such revenue.
Another common area of dispute is back-end overrides. If the buyer earns any, they are paid quarterly by major U.S. and foreign carriers and either quarterly or annually by other travel suppliers, depending on how large the buyer is and what consortium or franchise it belongs to.
If the buyer gets, say, a 2% market-share override from an airline (e.g., a quarterly payment based on the buyer's percentage of sales on that carrier versus other agencies' shares), calculation of the seller's share can be very problematic. If the seller's location's share was more or less than the share of the rest of the buyer's business, it is tough to decide what the seller has earned, if anything.
A third area of dispute is group business. Under the formula in your question, the seller is entitled to a percentage of the "markups," but in the case of group business, the markup is usually more than the clients' payment minus payments to the suppliers, and what else should be deducted is often a source of controversy.
I am not advising that you avoid all earn-outs, since you may end up with a higher price than if the buyer paid a fixed price, and since you might not be able to sell at all if every potential buyer offers an earnout. Rather, try to avoid formulas that, because of their complexity or uncertainty, could lead to disputes.