Selling your agency, a how-to guide, Part 4: Making the deal happen
In Part 4 of a series, columnist David Rodnitzky walks you through non-financial deal terms and offers tips on choosing the right acquirer and working with lawyers.
When evaluating different job offers, compensation is always a major factor, but it is rarely the only consideration: Job stability, compensation, opportunity, responsibility and environment all contribute to a decision on a new opportunity. (My mnemonic for this is S-C-O-R-E.)
Such is also the case with selling your agency: The financial terms of the deal are very important, but simply optimizing for money is not always the best decision.
Non-financial terms that matter
A few common conditions will come up in most agency acquisition negotiations: earn-outs, non-compete clauses, remedies, warranties, representations and covenants. Note that I am not a lawyer, so please don’t take any of this as legal advice.
Earn-out: An earn-out means that some of the compensation offered to buy the agency is withheld for a specific purpose after the acquisition is completed. Generally, there are two types of earn-outs: performance-based and time-based.
Time-based are the simplest to explain: Compensation is paid after specific team members have stayed at the agency for an agreed amount of time post-acquisition.
Performance-based earn-outs are far more complicated. Most performance-based earn-outs are based on the acquired agency’s ability to hit EBITDA (essentially profit) numbers over a specified period.
For example, let’s say that the acquired agency can earn up to $1 million in an earn-out. The acquirer might stipulate that the agency only gets the $1 million if they generate at least $250,000 of EBITDA in the first two years after the acquisition, or they may say the maximum earn-out is $1 million, but if the agency only reaches 50 percent of the $250,000 EBITDA goal, they still get 50 percent of the earn-out.
Earn-outs can be structured in an infinite number of ways: EBITDA vs. revenue, zero-sum vs. partial, accelerator bonuses for hitting certain performance milestones and so on. Lawyers have told me that disputes over the earn-out amount are the number one cause of post-acquisition litigation, so this is a term you want to negotiate very carefully.
Here’s but one example of how an earn-out term can be misleading or misunderstood: An agency negotiates the right to a $1 million earn-out, but only if they achieve $250,000 of EBITDA in two years. The agency completes the acquisition and then produces what they think is $250,000 of EBITDA. The parent company, however, uses a different accounting method than the acquired agency and argues that only $100,000 of EBITDA was earned. Who wins? The only winners for sure are the law firms representing both sides.
Non-compete clauses: Because agencies live and die based on the quality of their people, acquiring companies often demand that agency leaders sign non-compete clauses that prevent them from selling their agency and immediately leaving and starting a new, competing firm. Note that some states (like California) have declared non-compete clauses invalid on their face, but this does not apply when an owner is selling a company.
Because a lot of agency owners have no marketable skills other than working in an agency, a non-compete clause can effectively prevent an owner from getting a job for a period of time after the acquisition. Hence, when signing a non-compete, make sure that the compensation far outweighs the potential income you could make during the non-compete period, and make sure that compensation is enough for you to pay your bills!
Remedies, warranties, representations and covenants: When a deal is signed, everyone is excited about the potential for great things in the future. But what happens if things don’t work out as planned? For this reason, acquisition contracts have a slew of provisions that try to anticipate potential problems in advance.
Warranties and representations are things that both sides insert to ensure that the other side is being truthful about the state of their business. Examples might include historical revenue, client list, ownership rights, pending litigation, financial solvency and so on.
Covenants are a promise to do something in the future. For example, the acquiring agency may sign a covenant agreeing not to fire any C-level executive of the acquired agency without cause. Think of these as “after the deal is signed” protection for both sides.
Last but not least are remedies. A remedy specifies the consequences for a breach of contract (such as a breach of a covenant or misrepresentation). Having strong remedies (i.e., penalties that strongly discourage breaking the contract) will put all parties at ease.
Here’s an example of where all of these clauses might be relevant in a deal. Let’s say Acme Inc. wants to acquire Small Co. Acme Inc. signs a covenant that says that they won’t fire any C-level executives without cause until the earn-out period is complete. During the earn-out period, Acme Inc. hires a new CEO who doesn’t like the COO of Small Co. and wants to fire him. The remedy for a breach of the covenant, however, is that the full earn-out must be paid immediately. The new CEO decides the financial cost of contract breach is too high and decides against firing the COO of Small Co.
The above example also serves as an important point in mergers and acquisitions: The people who sign the deal may not be the people who enforce the deal, as executives come and go all the time.
So, while you may have a great deal of trust and respect for the people with which you are negotiating, it’s a good idea to assume that they won’t be around forever, and the people who come along in the future might not be as nice or trustworthy. So negotiate your contract assuming a worst-case scenario.
An important aside: Working with lawyers
The above list of contractual provisions is just a small part of the acquisition contract. You can expect that the final contract will be over 100 pages long and filled with provisions that only a lawyer could understand or love.
So for this reason, it is crucial that you “lawyer up” and get a great law firm to help you. In Silicon Valley, there are law firms that specialize in mergers and acquisitions work (M&A) and others that are generalists who can do M&A but don’t do it full-time.
I have heard of companies paying less than $25,000 to their firm to complete an acquisition, but the more common fees are in the $200,000–$500,000 range for an average acquisition. Yeah, that’s a lot of money, but this is also Silicon Valley, where a $20 hamburger is no big deal. If you live in a more affordable city, assume your costs will be less.
Ultimately, if you are selling “your baby,” and this is the most important financial deal of your life, my advice is to hire the best lawyer you can afford, even if that means paying six figures for a couple of months of their time.
I have anecdotally heard numerous stories of companies selling and then not getting what they expected from the deal due to a “gotcha” provision that they missed in the contract. (For a fun read, check out all the blockbuster Hollywood movies that — at least contractually — never made a profit).
There are things you can do to keep your attorney costs down. For example, you can ask a law firm to charge you a fixed fee instead of bill you hourly, or set a monthly cap on the hourly fees. You can also ask the acquirer to pay some of your legal fees upon closing. Lastly, you can always talk to other agencies who have already been acquired to make sure you are getting a fair rate from your law firm.
Choosing your acquirer
Let’s assume that you have offers from numerous acquirers, and each offer has the exact same financial consideration and contractual terms (This will never happen in reality, by the way); how do you choose a winner?
When I sold 3Q Digital, I based my decision on three factors: client satisfaction, team satisfaction and shareholder value (financial value). This may or may not be the list of factors that you value, but I do think it is important to think about what is most important to you before you enter into any negotiations.
However you judge acquisition offers, keep in mind that you, your team, your investors and your clients will be “in bed” with the acquirer for a long period. How much extra money would you need to sell to a company that you simply don’t respect, or who will treat your clients poorly, or who doesn’t share your cultural values?
For most agency owners, an acquisition will be the biggest financial event of their life, so the money certainly matters. But if you are like me, the reason for starting the agency wasn’t just about money, so the decision to sell shouldn’t be solely money-based either.
The good news for agency owners is that there are hundreds of other owners who have gone through the acquisition process already, and many of them have even sold to the same companies looking to acquire you. (This is particularly true if you are considering selling to a holding company. Most holding companies make numerous acquisitions yearly.) So reaching out for advice and experience sharing is pretty easy to do and highly recommended.
In my next (and final) column on this topic, I’ll discuss life after the acquisition is signed: how and when to tell your team and clients, how to maintain your culture, and how to work with your new owner.