HOUSTON BUSINESS REVIEW

Tutorial On Selling Your Business: “More Fundamentals on Selling” – Non-Competes and Earn-outs
By Ralph Fain

Ralph Fain is a principal in the R/ Fain Group, a professional business brokerage firm which confidentially represents the interests of sellers/ buyers of “Mainstreet to Mid Market” companies (revenues from $1MM to $25MM). Mr. Fain has over 20 years of broad business experience with Fortune 500 companies as well as with small/medium sized companies and has served in various capacities including Controller, Vice President, and President/CEO. Each week he will provide comprehensive information on the many aspects of buying/selling businesses.

          Continuing with our series on fundamentals when selling a business, today’s article deals with documents and/or mechanisms which are sometimes required by buyers to minimize their risk when purchasing a business.

          The first of these for discussion is entitled an Earn-out and could be deemed to be a subset or method of seller financing as well as a risk management tool. An earn-out mitigates a buyer’s risk in that payments to the seller are made over time, similar to note payments, but whereas note payments are generally constant over a period of time, payments under an Earn-out can fluctuate up or down.

          This is because the payments to the seller are calculated using some formula based on some type of operating results – e.g., a percentage (%) of sales, % of profits (with profits specifically defined), or some other performance standards or combination of same. In utilizing an Earn-out, the buyer is ensuring the seller has some “skin in the game” (sharing some of the risk) and that the seller accepts some of the responsibility relative to the ongoing success (i.e, growth and profitability) of the business on a post sale basis.

          Earn-outs can be structured where the seller is paid more than originally agreed (if the company does extremely well post sale and meets or exceeds certain metrics delineated in the agreement), where the seller is paid less than originally agreed (if certain targets outlined in the agreement are not met and/or the business declines post sale) and/or where the seller is not paid any additional amounts if the goals as agreed are not met. In some Earn-outs, minimums and maximums can be established so that the seller is not overly rewarded nor overly penalized; however, this type of arrangement obviously works against the buyer and tends to negate, or at the least to minimize, a fundamental purpose of the agreement. Just as the value of the business is negotiated, the value and the terms/conditions of the Earn-out are negotiated items between the buyer and the seller.

          Another method by which buyers mitigate risk when purchasing a business is via a Non-Compete Agreement. A non-compete agreement (or Covenant not to Compete) is a legally binding document (note: some states do not recognize the legality/validity of Non-Competes) prohibiting the seller of the business from competing with the new buyer/recently purchased company.

          Generally these agreements are for a specified period of time (1-4 or 5 years) and for a specified geographic area (within 10-35 miles of X). Agreements which are overly broad – e.g., within 500 miles of X and for 50 years – have been found to be invalid and unenforceable. The agreement must be reasonable in order to withstand and to prevail if challenged.

          Covenants not to Compete should address the following issues and/or areas at a minimum:

           - Type of business/business activity            - Time frame/duration
           - Geographic area covered            - Seller’s promise not to compete
           - Other rights of buyer            - Restrictions of seller

Historically, there have been instances where provisions of non-compete agreements have been inadvertently or unintentionally violated by the seller resulting in negative financial repercussions to same. Consequently, it is absolutely critical that the document be absolutely clear regarding its definition of “not competing directly or indirectly” and other terms and conditions. You do not want to jeopardize a portion of your sales proceeds due to an inadvertent breach of an unclear or misinterpreted Covenant not to Compete. As always when dealing with legal documents, the seller should engage the services of an attorney to prepare and/or to review this important document.

Although this article dealt with a “hybrid” of seller financing, our next articles will explore “true” Seller Financing in more detail – terms, protection, second liens, real estate notes, etc. As always, see you next time in this same space for our next discussion. Should you have any questions or require additional information please feel free to contact the R/ Fain Group at 832-646-0832 or via our web site.