What is an Earn-out? If you look it up on the web, it states that an earn-out is a provision written into some financial transactions whereby the seller of a business will receive additional payments based on the future performance of the business sold. When you hear the word earn-out, what questions appear in your mind? 

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In this article, we have asked an expert about earn-outs. This not only talks about the meaning of earn-out from a business point of view but you will also know how earn-outs work, benefits of it, when you will use it and more. This is a must read that will surely help you understand earn-outs more and how it will help you with your business.


Key Points:

  • An earn-out essentially means the seller must earn part of the purchase price based on the future performance of the business. Part of the purchase price is paid at closing and the remainder is paid after the closing, with the final amount to be paid based on the future performance of the business and if the seller meets the financial goals.
  • Simply put: to bridge price gaps.
  • This tool is also commonly used in larger business sales in the middle market where the buyer wants to incentivize the seller to realize goals in the future.
  • There is a lot of risk in any transaction that involves future conditions, especially when the seller is expected to work for, essentially, a new boss.
  • The amount of the earn-out primarily depends on the risk involved.

What is an Earn-Out?

An earn-out is a useful tool used in mergers & acquisitions and is commonly used by businesses in all different types of industries. It is an arrangement where the buyer pays the seller additional money if the business performs well after the closing. Earn-outs are a useful way to bridge a price gap between the perceived value the seller and the buyer have for the business. Price gaps are common in mergers & acquisitions. The seller, who is emotionally and financially invested in his business often believes the business should be valued higher than what the buyer believes the business is worth. Earn-outs are also commonly used when there is a disagreement about the expected future growth of the business, not just its present value.

An earn-out essentially means the seller must earn part of the purchase price based on the future performance of the business. Part of the purchase price is paid at closing and the remainder is paid after the closing, with the final amount to be paid based on the future performance of the business and if the seller meets the financial goals.

How do Earn-Outs Work?

A typical earn-out takes place over a three to five year time period and approximately 10% to 50% of the purchase price is structured as an earn-out. Earn -outs are popular with private equity groups, who do not always have the expertise to run a business and want to keep the owner incentivized following the closing. For example, if a seller thinks his business is worth $5 million and the buyer thinks it is worth $3 million, they could settle on an initial price of $3 million, and the $2 million difference would be structured as an earn-out, which would only be paid to the seller if the business performs well.

Why are Earn-Outs Used?

Simply put: to bridge price gaps. What is the value of a business? That depends on who you ask. Ask buyers what the value is of a business they want to buy and you will get one answer, and likely a much lower value. Ask sellers what their business is worth and you will get a very different answer, and likely a much higher value. However, if you ask accountants, attorneys, or other advisers, you will likely get completely different answers. When there is a difference in perception of the value of a company between the buyer and the seller, or, a difference in perception of the current value or of the future growth of the business, then an earn-out is a great compromise.  

Earn-outs are a useful way to bridge a price gap between the perceived value the seller and the buyer have for the business.

When to Use an Earn-Out?

When do you use an earn-out? When selling your business, use an earn-out if you are willing to bet on the future growth of your business, and if you want to be involved in the business after the sale. If you believe your business has a lot of unrealized potential, then an earn-out may be suitable for you. This tool is also commonly used in larger business sales in the middle market where the buyer wants to incentivize the seller to realize goals in the future.

Benefits of an Earn-Out

For buyers, structuring the sale as an earn-out protects them against overpaying for a company that does not meet its future goals. It is a way for buyers to force sellers to put some skin in the game, and to provide some financial incentives for the seller to be involved with the business after the closing. An earn-out can also benefit a seller because it is a great way to increase the amount the business will sell for. The seller has the opportunity to sell the business for a higher price than what the buyer would be comfortable paying outright.

Should I Consider an Earn-out?

When deciding to structure a sale as an earn-out, use caution. Earn-outs are prone to litigation. There is a lot of risk in any transaction that involves future conditions, especially when the seller is expected to work for, essentially, a new boss. The seller should realize that he or she is no longer in control of the business after the closing and during the earn-out period. The seller, who was once the owner and sole decision-maker of their business the day before closing must now understand that the conditions of the earn-out must be met on the buyer’s terms because the business is now owned by the buyer.

The seller should realize that he or she is no longer in control of the business after the closing and during the earn-out period.

Calculating the Amount of the Earn-out

First, determine how much of the purchase price you are willing to risk on the earn-out portion of the transaction. Most earn-outs are tied to the future performance of the business over a 2-5 year time period. For high-tech and service based companies, the earn-out may be as high as 60% to 80% of the transaction price. But for most companies, the earn-out represents 40% to 50% of the value of the business. The amount of the earn-out primarily depends on the risk involved. For example, if there is a customer concentration issue, and most of the revenue is generated by one or two customers, then the earn-out may be a very high percentage of the purchase price.

Basis for the Earn-out

A critical question to ask and consider is: what is the earn-out is based on? Is it based on revenue, earnings or some other criteria? Here are five ways an earn-out can be structured. All have pros and cons and the circumstances of the specific sale will determine what the earn-out should be based on.

1.Revenue – this is preferred by sellers and is the easiest to calculate, although revenue can be easily manipulated.

2.Net income – this is preferred by buyers, although these numbers can also be manipulated.

3.Non-financial targets - such as retention of customers.

4.Earnings, typically EBITDA – this can be manipulated through inflating expenses.

5.Gross profit – eliminates the possibility of the buyer inflating expenses.

Manipulating the Amount of the Earn-out

As was previously mentioned, a buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduced earn-out. Earn-outs are easily manipulated and should only be used if there is complete trust between the parties. If one of the parties wants to, they can easily manipulate the calculation of the earn-out. Take Google for example, they used earn-outs extensively when purchasing companies and would base the earn-outs on milestone-based compensation and other criteria. Now, however, they have stopped using earn-outs because they found it was too difficult for them to calculate the earn-outs because the data they were based on was so easily manipulated.

A buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduced earn-out.

Other Factors to Consider When Selling Your Business

Many sellers and buyers forget to take into account several other factors that can influence the earn-out. Here are some factors, in the form of questions, that can affect an earn-out and should be considered before one is entered into.

  • What if the buyer sells the business after the closing?
  • What if the buyer merges the business after the closing with another entity?
  • Will the seller have a right to inspect the buyer’s books after the closing?
  • Will the purchase agreement allow the seller to leave the business in the seller’s control, or largely unchanged after the closing?
  • Will the seller make sure that the business can be run independently after the closing?
  • Who is the judge - who will decide on the final calculations of the earn-out?
  • How will the progress of the earn-out be evaluated?
  • When will the progress calculations take place? Is it at the end of a set time period? Is it monthly, quarterly or annually? Is it allocated on a regular basis or in one lump sum?
  • Will the purchase agreement define all payments as non-refundable? This would prevent the buyer from later trying to reclaim some of these payments if the seller does not meet the pre-determined goals.

When structuring an earn-out, avoid cliffs. Earn-outs should not be all or nothing. Rather, they should be on a graduated scale. For example, if the seller must achieve $10 million per year in revenue, but that year he only achieved $9.9 million, then he should not forfeit the entire earn-out payment. Instead, he should still receive a portion of the earn-out. Whenever there is a cliff in the calculation of the earn-out, there tends to be a lot of disagreements and manipulation of the calculation.

Finally, you want to hire the best advisers that you can because earn-outs are so subjected to litigation. Have the right professionals in place to help the earn-out be a success.

Earn-outs tend to work very well when the seller is going to run the business the same after the closing as the seller ran the business before the closing. 

When Earn-Outs Work Well

Earn-outs work very well if your company has a track record of meeting budgets and projections. Earn-outs are used commonly for the following scenarios:

  • Concentration of customers, clients, key employees, where the earn-out would be contingent on retention of customers, clients, or key employees after the sale;
  • Volatile industries, where there are major changes within an industry and the seller still wants to sell despite those changes;
  • Supplier retention issues, or if the business is highly dependent on one supplier, and the earn-out is then structured on the retention of that supplier;
  • Distressed businesses.

Earn-outs tend to work very well when the seller is going to run the business the same after the closing as the seller ran the business before the closing. Certain types of companies that often use earn-outs include the following: consulting companies, companies where the owner is responsible for much of the sales, companies where there is no formal management team, companies whose family members are heavily involved in the company, and professional practices.

Tax Implications

Earn-outs are mostly treated as an installment payment, which allows the taxes to be deferred. They are also used for tax strategies in mergers & acquisitions. We recommend that you consult with your CPA or tax advisor to consider the tax implication of the earn-out before considering one.


Conclusion

An earn-out is an indispensable tool to close more transactions. However, selling a business in this way has its share of risks, and buyers and sellers should take precautions when using an earn-out. Hire the absolute best advisers you can and carefully draft the purchase agreement to accurately and completely address the earn-out. Earn-outs are very subject to litigation, so hire an experienced attorney. When used properly, earn-outs are a very powerful tool to bridge price gaps and sell businesses in a way that benefits all parties involved.


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