Mark Pestronk
Q: A prospective buyer of my agency has sent me a letter of intent containing what I think is a pretty good offer. He will pay me $250,000 plus 30% of the net profits of my agency for five years. The profit payments should enable me to finally retire if the agency remains profitable. Are such offers typical today, and what would you say are the risks involved in such a deal?
A: Payments based on profits of your agency are very unusual and very risky. They rarely work and often lead to disputes.
There are three separate sets of risks involved in gearing post-closing installment payments to profits, as opposed to commission or fee revenue. First, the seller typically has no control over what expenses the buyer incurs after closing, so it is within the buyer's control to suppress or even eliminate all profits by increasing the expenses of your former agency.
For example, the buyer could give all employees a large raise to bring them up to parity with the buyer's employees from other businesses, or the buyer could add to staff. All such steps would depress or eliminate profits.
The second set of risks arises because sales or revenue typically decline after an entrepreneurial business founder/owner leaves the business, so the net profits will tend to decline, too. Unless the new owner pays particular attention to maximizing sales and revenue, a typical agency would probably lose 25% of its clientele every year for several years after an acquisition. Over five years, there may be no business left.
The third set of risks is definitional: there is no generally accepted definition of "profits" in the worlds of accounting or law, so what the buyer means and what the seller means can be two very different things. Failure to spell out what exactly what goes into calculating profits can be disastrous for the seller.
Let's use a real-life example. Before a sale, an agency owner was making about $400,000 per year in profit, as he understood it. This figure included items that he expensed but that were really profit-like to him, such as expenses for his car, cell phone, club dues, charitable gifts and travel. The seller's income statements and tax returns typically showed almost no net income because of all these personal-type expenses.
The agreement stated that the seller would be paid 30% of earnings before interest, taxes, depreciation and amortization, or EBITDA. That acronym is used in business every day; you will hear it whenever a public company announces its financial results.
Naturally, the seller thought that, after the sale, the buyer would not incur those personal-type expenses and would therefore show net income of about $350,000, entitling the seller to about $105,000 (30% of $350,000) per year. However, the buyer's post-sale calculation did not add any such expenses back to profit, so the new level of profit was actually close to zero.
When the seller asked the buyer why he did not add back these personal-type expenses, the buyer said that they were not required to add back anything except interest, taxes, depreciation and amortization. So, the seller got next to nothing because he mistakenly thought that EBITDA meant profits as he customarily understood them.
So, to make a profit-based formula work, a buyer would also have to agree not to incur any new or higher expenses, keep the agency in operation, provide the same levels of service that you did and add back to profits all the same personal-type expenses that you did -- all for five years. If that sounds ridiculous, you now know why I say that profit-based formulas rarely work.