Earn-outs can help close deals and benefit both buyers and sellers. But sellers need to avoid some of the pitfalls of earn-outs. First, what is an earn-out? The short answer is that earn-outs are a creative way to close the gap between the seller’s expectation on price and the buyer’s fear that they are paying too much.
Earn-outs can help close those situations where the seller is excited about the “potential” growth of their business in the next few years, yet the buyer wants to see it first. The seller wants to receive the full asking price for the business based on what the business would be worth with all of those new contracts and additional growth. But the buyer says “no, I‘m not willing to pay for that until I see it.” That difference could be in the thousands or the millions. Earn-outs can help close those deals.
An earn-out is a deal structure where the buyer pays the seller a down payment to purchase the business with the balance paid over a set period of time based on pre-defined performance metrics. Negotiating that structure is where the pitfalls can come in. One of the keys to earn-outs that work for the seller is to keep the structure simple. Earn-outs should be based on specific, measurable performance or events. The greater the complexity, the more likely there will be future conflict and the earn-out won’t be paid.
Examples of measurable events include things like: winning a competitive contract, renewing specific contracts, landing new customers, retaining key employees, attaining specific revenue goals and maintaining defined gross margins. The earn-outs can be paid quarterly, semi-annually or annually for the specified period. It’s a good idea to keep the earn-out period around two years or less.
Pitfalls to avoid? You should steer away from defining earn-outs based on net profits or EBITDA. The reason is that when the new owner takes over, those things will change. The seller will have no control over those calculations any longer. The earn-out should not be based on numbers that the buyer can later manipulate.
When negotiating earn-outs, the seller will want to make sure that the earn-outs are beneficial to the buyer, so that it works for everyone. Also, the seller should plan to remain with the company through the earn-out period to ensure that the performance metrics are met. If the buyer is a foreign company, the seller should consider asking for an earn-out escrow account to be established. Both parties will want to consider their own tax implications.
Finally, the seller and the buyer should be sure to capture all of the details of the earn-out in writing. The greater the level of complexity, the more important a written agreement becomes. Again, we advocate for simplicity as well as written. Simple, measurable metrics are easier to contractually enforce and more apt to be a success for everyone. When done this way, pitfalls will be avoided and earn-outs can help close your deal.