Earn-Outs: Things to Consider

Earn-outs are often used as part of the sale of a company when the buyer and seller do not agree on the purchase price and/or have differing opinions about the future growth and performance of the company.

It is a deal-making tool that can bridge this value gap. If the buyer and seller can come to terms on the purchase price, then there is no need for an earn-out agreement.

In an earn-out, the original owners are paid an agreed upon price for the business, which is generally lower than what the seller is asking. Then, the seller is entitled to additional compensation based on the future performance of the business. The seller may (or may not) be asked to stay with the company to help achieve these goals.

If the company achieves or exceeds the performance targets the prior owners net more from the sale of their company. If the company does not achieve these goals, the buyer has protection against overpaying.

Earn-outs should not be confused with seller financing. Seller financing is a loan provided by the seller to the purchaser. Similar to a bank loan, the debt is paid back over time with interest. It is often used when the parties agree on a price, but the buyer cannot secure enough cash to buy the business outright.

Clearly there are risks with an earn-out, but it is preferable to walking away from the deal. And, if the seller is bullish on the business, there should be less concern on his (or her) part. Here are a few things to think about:

Metric: Most earn-outs are tied to the company’s performance, such as sales, earnings, or some other measure over a three-to-five-year period.

Sellers usually prefer to keep the measure unambiguous and as close to the top line of the income statement as possible, such as revenue. Not surprisingly, buyers generally prefer a bottom line measure such as net earnings. It is best to keep it simple and easy to quantify.

Financial Resources: The seller will want to be sure the company has resources and is committed to achieving the performance goals. For instance, if the seller has been asked to stay on to achieve certain sales targets, then you want to be sure the marketing budget stays intact.

Key Players: Similar to keeping the necessary financial resources in place, it is also important to retain key employees that are critical to realizing the goal.

Control: If you are asked to stay on, make sure you have management oversight over any departments that execute on your goals. Again, if your goal is new customer acquisition, then you better have oversight of the sales department.

Length of Term: Keep it as short as possible. Things change, and you have better visibility into the short-term, rather than the longer term. Besides, you want to get paid, right?

Processes: Be sure to have clear processes in place to both measure performance as well as pay out the incentive. It is always good to include an example in the earn-out agreement. Define a process to resolve any disputes that might arise.

If you are thinking about incorporating an earn-out in the sale of your business, keep it simple and understandable. And, be sure to engage experienced legal and financial advisers to help you work through the nuances.

If you would like to discuss how we can help you structure an earn-out agreement, please give us a call. We would be happy to help.