People who are considering purchasing a business right now might have concerns about how these companies may be adversely affected if a full-blown recession were to appear.
There are a couple of things you can do to protect yourself. As you probably know, someone who purchases a business is buying future earnings more than anything else. So if future earnings are at risk, the business probably isn’t worth what the seller thinks it is (if he is using historical earnings).
One way to take the risk out is with an earnout agreement. An earnout agreement basically says, “Hey, I’ll pay you a safe (low) price for your business, then I’ll pay you more should the business do what you say it will do.” It’s a performance based bonus. Sellers don’t like it because (rightly so) they will be depending on you the buyer not to screw up the business. But earnouts are increasingly used in times like this where there may be some doubt about the future.
Earnout agreements can easily become complex agreements with different milestones, timelines and payout schedules. These rarely work and I’ve heard of buyers and sellers ending up in court over complex earnouts. It is best to make it as simple as possible. Base it on annual gross sales, or at least gross profits, but not earnings. Even though all you really care about are earnings, they are too easily manipulated.
Another way to take out risk for shorter term periods is with a holdback. With a holdback the seller doesn’t get all the payment up front. The funds stay in escrow until a specific condition is met. Perhaps landing a big account that the seller believes will happen. If the condition isn’t met by a certain date, then the funds are released back to the buyer.
Many buyers should pay more attention to due diligence (reviewing the books and agreements before closing a deal) in good times, but it is especially important when times are tough. Unfortunately, when it comes to money, I’ve seen seemingly good people act in questionable ways. In other words, dive in and really check things out and don’t be afraid of spending money on a CPA to help.
You can also review some of the other articles I have written on buying a business: