Considerations of an Earn-Out

Acquisitions come in all shapes and sizes, and can be structured in many different ways. Some are all-cash deals, but more frequently deals consist of a combination of cash, financing, stock and sometimes earn-outs.

An earn-out is a provision written into the purchase contract that allows the seller to receive a portion of the purchase price in the form of additional future payments based on the future performance of the business. Those future payments may be tied to future sales, gross profit, net income, key client or employee retention, new business development, market segment development and more. Earn-outs can be a good option to bridge the gap between how a seller and buyer each value a business, or to create incentives and goals for the future of the company. A buyer may expect a conservative price based on the company’s past performance, and the seller always wants the highest and best price for the company.

Sellers can benefit greatly from an earn-out, as there is the potential to earn significantly more money than they might from another structure. And buyers can greatly benefit from a lower risk investment and from the performance and commitment of a highly-motivated employee. Because earn-outs can be anywhere from a number of months to several years, there can be tremendous up-side, but if the buyer doesn't pan out, the future payments could be lost.  Some earn-outs can be capped at a certain time period and others capped at a certain dollar amount. Others might look for a minimum threshold no matter how long it takes.

That said, both sides must be realistic and committed to the arrangement. Are the milestones realistic? Are they aggressive enough? If the seller is going to remain involved, do they whole-heartedly embrace becoming an employee who has to work as hard as they did as an owner? Are both sides willing to invest additional time and money to iron out the details required? 

Talk with your M&A advisor to determine whether an earn-out is a good option for you. Create a long-term plan with realistic, achievable financials to help project your potential future earnings. Also discuss the commitment you will need to make to your new role in order to earn the future funds. Will you have the authority to make decisions that will drive your success? Did you learn enough about your buyer during due diligence to feel comfortable taking on a long-term relationship?

Earn-outs can bring life back to a deal that might have otherwise fallen apart. Work with your M&A and legal advisors to be certain the terms of the deal are crystal clear. There should be no gray areas, no ambiguities about what constitutes achievement of milestones. If your shorter-term goals of maximizing your earn-out payments are consistent with the buyer’s long-term plans for the company, the benefits can certainly outweigh the risks.

For additional information or for advice, contact us at 913-648-0185 or by email.