Mark Pestronk
Q: You have often written that, in most travel agency acquisition agreements, at least part and sometimes all of the purchase price is paid as a percentage of commissions and fees generated during the one, two or three years after closing, and that such deals are called "earnouts." I have some questions about earnouts. First, if neither the buyer nor the seller has ever done an earnout before, how would they formulate one? Second, what is the typical payment interval after closing: monthly, quarterly or annually?
A: A typical earnout formula today is $X paid at closing (i.e., the date on which the agency is sold) and then Y% of commissions and fees collected during the two years after closing. Here is how you can logically calculate X and Y, although experienced buyers may well have their own formulas:
First, the parties need to derive a hypothetical value for the agency. The best way to measure an agency's value is as a multiple of recast profits. "Recast profits" mean the agency's net income for the most recent 12 months, plus owner compensation in excess of what a general manager would earn, plus expenses on the income statement that personally benefit the owner, such as car payments, or that are out of the ordinary, such as the cost of office moves.
Second, you would multiply the recast profits by a number reflecting what similar-size agencies are selling for. For an average-size agency, the typical multiple is three, so the hypothetical value is three times the recast profit for the most recent 12 months.
Third, the down payment would typically be about 20% of the hypothetical value. Thus, if the hypothetical value were $300,000, the down payment would be $60,000, which is the X referred to above.
Fourth, the balance to be translated into an earnout would be the hypothetical value of $300,000 minus the down payment of $60,000, or $240,000. However, instead of paying a fixed $240,000 in installments, an earnout would be calculated by taking the percentage derived by dividing the balance of $240,000 by the seller's last 12 months of commissions and fees.
For example, if the seller's last 12 months of commissions and fees were $400,000, then 240,000 over 400,000 would be 60%. So, if the earnout's length were just one year, then the buyer would pay the seller 60% of the sold agency's commissions and fees collected during the year after closing.
Fifth, since the typical earnout term is two years, you would divide the earnout percentage by two, so that the "Y" referred to above would be 30% of commissions and fees collected during the two years after closing.
With an earnout, if the commissions and fees stay the same during the two years after closing as they were during the 12 months before closing, the seller will receive exactly the hypothetical value referred to above. If the commissions and fees are higher, then the seller will receive more, and vice versa.
Earnouts are typically calculated and paid monthly, so that, in my example, the buyer would pay 30% of commissions and fees for 24 months.
Remember that what is typical is not necessarily what your deal will be, and if you feel that your agency should sell for more, don't be discouraged by my generalizations.
Mark Pestronk is a Washington-based lawyer specializing in travel law. To submit a question for Legal Briefs, email him at [email protected].