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What is an Earn-out and do I Need One when I sell my Business?

March 27, 2014

Why an earn-out structure might make sense for you.

Buyers and sellers often have different views when it comes to deciding on the value of a target company. An earn-out is a common way to resolve those differences of opinion. An earn-out allows buyers and sellers to disagree on the actual valuation of the company, but to come to an agreement on the transaction.

In a typical earn-out, a buyer would agree to increase the final purchase price to be paid to the seller based on the future performance of the acquired business within a certain period following the closing of the transaction. In addition, the final purchase price may be fixed or determined through a formula based on achievement of certain milestones, such as revenue, gross profit, operating income or an defined earnings stream. Typically, an earn-out period is between one and three years following the closing of the transaction.

Buyers generally seek to base earn-outs on the bottom-line earnings, such as operating income. In contrast, sellers usually prefer earn-outs based on revenue, as revenue is easily measured and the seller is not at risk for increases in overhead and general and administrative expenses that the buyer may add to the operations.

Because most earn-out clauses are tied to the company’s performance over a certain period of time, buyers and sellers need to have a clear picture of their expectations. If a company has a track-record of performing at or exceeding forecasts in the past, this fact will not be overlooked in the negotiations.

Having a good idea of what to expect from a company’s operations is critical because it directly impacts the range of earn-out terms that could be offered. A seller might want to receive 90 percent of the total purchase price upfront with the remaining 10 percent paid in cash after a year. Alternately, the buyer might offer to buy the business for 50 percent upfront with the remaining value being paid over a three year period during which time the seller must agree to stay with the company and optimize its performance. All of these terms are part of the negotiating process.

Pros of Earn-Outs
There are a number of reasons earn-out structures make sense:

  • Earn-outs tend to bridge the gap in the difference of perception of value between sellers and buyers.
  • Earn-outs provide a means of transferring some risk from a buyer to a seller. A seller with high performance goals and expectations accepts a contingent payment while the buyer, likely less informed about the seller’s future projections, is able to shift the valuation risk to the seller.
  • Additionally, an earn-out can act as an incentive for the seller and key employees to remain in place and commit to the business after the acquisition.

Cons of Earn-Outs
There are a few negative aspects to earn-outs:

  • Earn-outs may put off post-acquisition integration of the target company into the buyer as the buyer needs to independently account for the financial performance of the target company during the earn-out period.
  • An earn-out can get extremely complicated and can create definitions and performance standards that may be difficult to administer. Measuring the results may pose serious difficulties.
  • Earn-out may emphasize short-term profits over long-term growth if key management remains in the business with an incentive to maximize income at the expense of the long-term interest of the business.

Reference: “Middle Market M&A” by Kenneth H. Marks, Robert T. Slee, Christina W. Blees and Michael R. Nall.

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