Veterinary hospital prices have materially since 2016, leading deal structures to become increasingly complex. Buyers now aim to align incentives and mitigate risk with every acquisition, employing deal structures like joint ventures or offering TopCo equity to safeguard their interests. For those practice owners who would have significant upside by selling later due to high practice growth, buyers will sometimes offer earnouts to encourage those owners to sell immediately, and to share upside post-closing with the seller. For the more risk averse buyer, they will utilize contingent notes or contingent payments more frequently to protect their downside risk.
What is an earnout?
An earnout is a future payment to the seller based on achieving specific performance targets that are defined before the transaction closes. Historically, earnouts have been based on profit or EBITDA targets, but they are progressively moving to revenue-based targets instead.
The shift away from EBITDA based targets is primarily due to sellers having significant success in late 2020 and 2021; they grew their practices post-Closing at a rate greater than historical numbers, leading to larger-than-usual earnout payments. In response, revenue and EBTIDA-based earnouts still occur but now may have a cap on the total dollars that can be earned. A cap on the amount gives the buyer more visibility; they now have a clear picture of the maximum amount of additional purchase price that they’ll pay.
Many earnouts have a hurdle that must be achieved before the earnout applies. These hurdles commonly require revenue or EBITDA growth to deliver above market expectations, so an earnout generally would not apply at market levels of revenue or earnings growth. The longer the time frame for an earnout, the higher both the hurdle and the cap.
Why earnouts?
Earnouts are put in place to induce the seller to close before the benefits of their initiatives are fully realized. However, this upside needs to be balanced with buyers that do not want to pay a seller for changes that the buyer can drive – for example, better vendor contracts or average levels of growth.
When does an earnout make sense?
While every situation is different, buyers typically offer earnouts to practice owners in the following events:
- The seller has hired one or two new DVMs who will grow the practice but have not yet been on-board long enough for their production to fully impact the profitability.
- The practice has historically grown well-above market rates — generally 12 percent or more revenue growth for several consecutive years.
- The seller recently (past 3-6 months) initiated and made changes to the cost structure that are not fully seen in the financial results yet, however, the buyer will gain the benefits of those cost changes.
- The seller is in the midst of or contemplating an expansion project which will drive significant growth at the practice.
What should I look out for?
Earnouts are structured in a variety of ways. Regardless, it’s important to know the market to ensure you receive appropriate value for the upside that your practice delivers. Unfortunately, we have seen earnouts that only give small financial rewards to the seller for delivering outsized returns to the buyer – which obviously isn’t symmetrical or ideal.
As a seller, you should realize that most buyers will not offer earnouts without clear data and information about the upside potential of your veterinary hospital. Negotiating these terms is a complex process and requires experience and market data to back up your interests. A trusted advisor like Ackerman Group can help you understand these terms, work effectively with buyers on your behalf, and negotiate the best deal.
What are contingent notes?
We’re explaining contingent notes (or contingent payments) in the same article as earnouts because they are essentially opposites. An earnout provides upside for the seller, while contingent notes provide downside protection to the buyer. Contingent notes are a portion of the purchase which is withheld and paid upon meeting specified metrics post-closing. With contingent notes, if something goes wrong with the veterinary hospital in the immediate years after closing, the buyer will pay less for the practice as a result. Contingent notes are also put into place to ensure retention: they force the seller to meet their post-closing employment obligations and make sure they won’t leave before their employment agreement ends.
A handful of buyers use contingent notes to protect their investment in the practice. Contingent notes can sometimes be simple, like: if you work all three years of your contract, you receive the money. Other contingent notes are more complicated and may have production targets for the seller or revenue targets for the hospital. Usually contingent note targets are reasonable and are there to ensure the business revenues maintain current levels or grow.
At Ackerman Group, we see contingent notes more frequently with smaller, two and three-doctor practices where the risk level is higher than a larger practice. However, some buyers do make contingent notes a part of all their deals, aside from size.
These deal structures are complex and involve risk for the seller. Having experienced advice helps to ensure the terms of these contingent payments are appropriate with the market and minimize your risk as much as possible.
Ackerman Group guides veterinary owners in corporate practice sales. To learn more about what we do, or to receive guidance tailored to the sale of your practice, contact us to get started.