A business owner’s dream is to exit their business on their own time frame and receive what they believe their business is worth, in all cash at closing. But that rarely happens. Most of the time, transactions consist of a combination of cash at closing, seller notes and sometimes an earn-out.
Perhaps there is a difference between what the seller believes the business is worth and what the buyer thinks it’s worth. Or maybe the ideal buyer doesn’t have the resources to pay what the seller wants for the business. In either case, an earn-out can be a good solution for both parties.
An earn-out is defined as future payments to a seller that are contingent on agreed-upon milestones of the company’s success. If the seller believes there is significant growth potential for the company, and if the buyer believes the seller can contribute greatly to that growth, an earn-out can benefit both parties.
The benefits to a buyer include the ability to delay payment until growth is realized, assuaging the fear of overpaying for a business that fails to thrive, and not paying interest expense on debt. Buyers feel more confident about their purchase if the seller keeps skin in the game.
The biggest benefit to sellers is the opportunity to receive significantly more for the business than they could have in an all-cash deal. And some sellers value the ability to spread out payments for tax purposes. The upside to the seller can be tremendous, but only if the earn-out is structured properly. Significant thought and preparation should be given to the following issues when considering an earn-out:
- Since most earn-outs are tied to the company’s performance over the two to five years after a sale, sellers should be honest and accurate with their forecasts over that period. If the business has a history of meeting or exceeding forecasts, the business owner can feel confident about achieving the earn-out goal and will gain power to negotiate favorable terms. Sellers should be prepared to document and defend financial projections for the agreed-upon time frame.
- If the seller plans to walk out the door shorty after closing, or work a lot less than before the sale, achieving the earn-out will carry more risk. Sellers should be prepared to assist the buyer in every possible manner to help assure the success of the company and their future payout.
- While the seller no longer owns the company, they may desire to have a certain amount of control to ensure the earn-out is realized. For example, if new ownership eliminates the marketing budget, the seller may not be able to achieve established goals. Sellers can’t be accountable for what they can’t control, so it’s important to negotiate in advance any changes the new owner intends to make regarding reporting structure, retaining key employees and other factors that will impact attainment of the earn-out.
- Spend time with the buyer before the sale to understand the culture he or she intends to establish. See if the two of you have chemistry and would enjoy working together. Motivation must remain high for the earn-out scenario to benefit both parties.
- Keep it simple so there are no misunderstandings. Avoid a complicated calculation with many variables that can be misunderstood by one party or the other and make achieving the earn-out impossible. Determine in advance how success will be evaluated and measured. A clear and simple structure with buy-in from both sides will eliminate any conflicts when it’s time for payment. Most earn-outs are tied to revenues or gross profit.
- Currently the SBA does not allow an earnout with SBA financing, so keep that in mind when negotiating a deal with the buyer.
With any large potential upside for the seller comes a certain amount of risk if the above factors are not addressed. Earn-outs can be a game-changer for sellers, but only if structured correctly. Your M&A advisor will guide you through the mine field to create an agreement that benefits both sides. For more information or for advice from O’Keeffe & O’Malley, call 913.648.0185 or email firstname.lastname@example.org.