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What is the best way to structure an offer tied to future earnings?

Any offers I intend to make would be tied to future earnings of the business. Should that be done on EBTIDA, Gross Revenue or Cash Flow? Or is there yet a better way.

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I would suspect that a seller with any financial skills is going to want any offer to be tied to a number that would include any benefit you receive as the new owner (Cash Flow) over the buyout period. The offer in writing must be VERY specific about what is or isn't included, not only on the expense side, but also on the income side. Don't expect the words "Cash Flow" to be a clear and binding term in any agreement. The new owner can alter the business model in a way that can greatly change both income and expense.

Consider making an offer that locks the seller into the current date even though the actual closing date may be 90 days in the future. In other words, you are to benefit from the profits (or losses) and are involved in any decisions during the due diligence period. This can help protect you from the owner taking some quick profits or making changes in inventory or other items that can leave you with a uphill battle from day one.

I structured one sale as follows:
1. Business income/losses were to buyers benefit two weeks prior to my offer. The seller was paid a reasonable salary until closing. (We closed about 60 days later and I worked and was involved in most of the transactions in those 60 days).
2. Seller received 15% of the cash flow for 3 years based on the current business operating procedures. In other words, if I did something drastically different (good or bad) then, the seller still got 15% of what the normal cash flow would have been. This can be complicated if you do something crazy during the buyout period.
3. Values assigned to the different assets (non-compete, FF&E, inventory, goodwill, etc) can have a significant tax impact to both the buyer and the seller. I always involve my attorney who is also a CPA. Not easy to find one, but he is worth his weight in gold (well, maybe silver). Make sure he has lots of experience in similar business transactions. If he doesn't, he can really screw the deal up!

My sales are in the millions, so this may not be practical for a very small transaction, but maybe it will give you a few ideas.

If you prepare for surprises, there won't be any.

Remember: A fair agreement is when all parties are equally dissatisfied.

Jan 30, 2011