Q: I am considering making an offer to buy another agency, and I need some advice. Although I will make a substantial down payment, the rest of the purchase price needs to be geared to the future performance of the business that I buy. I understand that this sort of formula is called an "earn-out." I have heard of earnouts based on any of three measurements: the business' sales, revenue or profit. Of the three, which is the most common for an earnout deal, and which do you recommend and why?
A: Of the three kinds of measurements, revenue is, by far, the most common. Second would be sales. Profit would be a distant third.
However, each measurement has something to recommend it, so there is no inherent reason to choose one over the others. It depends on the parties' risk tolerance, the buyer's motivation for buying, the seller's role after the sale and whether the seller's location will remain open during the earnout period.
Let me first define these terms as I use them, since one person's "sales" can be another person's "revenue." By "sales," I mean the value of transactions invoiced to clients. The term is synonymous with "turnover."
The beauty of using sales is its simplicity: You can just add up the invoices. However, many travel businesses do not even measure sales; the top line of their income statement is commission revenue or markup.
Further, for nonairline sales for which the supplier is the credit card merchant, such as hotels and car rentals, there isn't necessarily any relationship between what the seller has invoiced to the client and the commissionable sale. Therefore, many savvy buyers and sellers would deem a sales-based earnout somewhat arbitrary.
If you, like most buyers, are more interested in the bottom line than in gross sales, you would be better off gearing the earnout to revenue or profit.
By "revenue," I mean commissions, overrides, fees and markups. You can get the same result by measuring sales minus the cost of sales. Revenue is the same thing as "gross profit" in accounting.
Finally, by "profit," I mean net income from the income statement, excluding interest, income taxes, depreciation and amortization (aka EBITDA). In theory, profit is best for buyers because it directly measures what the buyer is usually interested in.
However, using profit as a measurement is usually unacceptable to sellers because, once the buyer is in control, the buyer can add whatever expenses it wants and thereby suppress or even eliminate profit. These formulas tend to work only when the selling owner will continue to run the business after the acquisition, the business will stay in its current location and the buyer's right to add expenses is limited.
Using revenue as the yardstick is a good compromise because it is fairly measurable, bears a reasonable relationship to profits and doesn't depend on the buyer's expenses. If a seller knows that the buyer's commission rates are higher than the seller's, the revenue formula provides a way of increasing the purchase price over what the seller might otherwise have received.