We like to blog about buying and selling pot businesses. It’s a rich topic and the transactions can be memorable for both entrepreneurs and attorneys. In our recent posts, we have canvassed subjects from diligence items for buyers to checklist items for sellers. We also have covered important transactional topics such as how much your cannabis business may be worth and what you can actually sell. Today’s entry covers a structural part of many business sale agreements: the earn-out.
An earn-out is a contractual provision that entitles a seller to additional compensation in the future, if the business achieves stated financial goals. Earn-outs are used when the asking price for a business is more than a buyer is willing or able to pay up front. A well drawn earn-out can bridge the valuation gap between an optimistic seller (pretty much all of them) and a skeptical, cash-strapped, buyer (just some of them). It can also provide a buyer with additional financing. In an industry where hard money is the rule and bank loans are not available, that can be compelling.
The primary objective in an earn-out is to allow the buyer to make payments over time. The earn-out may also require the seller to step into a consulting role post-sale, and actually “earn” the post-transaction payments. In those cases, it is important to clearly outline the parties’ expectations. This scenario makes for a less clean break, but sometimes a seller has invaluable expertise and experience—particularly in a local marijuana market—that can be passed along with the sale.
In addition to seller support, there are many factors to consider in negotiating an earn-out agreement. Five important ones include: (1) the earn-out period; (2) payment structure; (3) payment schedule; (4) performance matrices; and (5) accounting standards. Earn-out payments may also be capped or uncapped, and the parties can stipulate that future events (like federal enforcement action, for example) will offset earn-out payments. Depending on the type and size of the deal, and the parties’ personalities, an earn-out can be simple or extremely complex.
If the goal is to keep things simple from both a payment and audit perspective, the parties will choose an easy-to-peg accounting and payment metric. For example, sellers often suggest an earn-out based on sales, because this line item is never disputed and the calculation is simple. A buyer, on the other hand, may push for an earn-out based on net income, as this metric accounts for all nuances of a business’ operations. A middle road would peg the earn-out at a multiple of EBITDA, usually over a certain number and in each relevant year. Ultimately, simpler calculations mean fewer disputes.
Given the nature of federal law, the earn-out metric for a pot business must also consider factors mainline businesses needn’t entertain. One of these is the oppressive effect of IRC 280E, the tax code provision that cuts into marijuana business profits. Another is licensing implications at play in the relevant state: readers of this blog know that states have strict rules on who can hold a financial interest in a pot business, and how that interest may be postured.
At the end of the day, many deals in the cannabis industry are structured to account for a lack of institutional financing. Like the marijuana sale-and-leaseback or the ubiquitous seller carry, an earn-out may be a way for a cash-light market entrant to gain a toehold in state-legal cannabis. We expect that earn-outs will remain an attractive option for the industry until things change at the federal level. Given the current shape of things, that could be a while.