What’s an “earn-out”?

Essentially, it is a pricing structure used in mergers and acquisitions where the sellers of a business must “earn” part of the purchase price based on the performance of the business following its acquisition.

Many business transfers – especially those in the lower Middle Market – are financed using what is known as an earn-out. It essentially means that a buyer will pay a seller X if the seller stays with the business for a certain period of time and the business performs to certain stipulated standards; usually, certain revenue or earnings targets. Earn-outs are popular among private equity investors, who usually do not have the expertise to run the target business after closing, as a way of keeping the previous owners involved following the acquisition.

There is no standard set of numbers that make up a common formula but the concept is the same. An “earn-out” means that the seller “earns” the agreed-upon price over a period of time that may range up to five years. An earn-out is generally structured so that the final acquisition price is ultimately determined by the performance of the business over the earn-out period.

If you’re a business broker, managing the seller’s expectations is one of the more important aspects of your job. From advising on the time a sale will probably take and what the buyer’s due diligence is likely to entail to the potential sources of financing the purchase will involve and the possible structure of the transaction’s terms – including the chances that a buyer will want the seller to stay on for a period – you need to advise your clients on what they can expect during the process of selling their business.

The value of a business – at least from the buyer’s perspective – is based on what the buyer expects the business to earn in the future. The more the buyer believes the business will earn, the more the buyer will pay for that business; i.e., the more the business is worth.

The Highest Price and Best Terms

Another of the business broker’s responsibilities is to try to get the highest price and the best terms for the client. Most small businesses are valued based on the earnings of the past three to five years, the trend that that those numbers show and the extrapolation of that trend – at least to the extent that such extrapolation can be justified. There are exceptions, of course.

For instance, if a business’ revenue has increased at an average annual rate of 20% over the past three years but a major customer’s purchase contract will expire in nine months, the buyer will be far less interested in the revenue trend line. The buyer could justifiably argue that the business, without that purchase contract, is worth much less than the preceding years’ results would suggest. However, the seller, if properly prepared by his advisors, might counter with, “If I get that contract renewed for another three years, the business’ value will be much higher – and probably could be based on the trend line.”

That is a WAY simple explanation of an earn-out but it is a clear example of the concept.

Valuation

An earn-out is a provision in an acquisition agreement that allows the seller of a business to receive more compensation if the company being sold reaches certain goals. As I’ve written in the past, business owners often have an inflated opinion of what their business is worth. A professional business broker will insist on having a valuation done so that buyer the broker and the seller know what the market is likely to value the business at and what, if any, options exist to increase its value.

Even in the face of a professional valuation, some sellers may take the position that the valuation is incorrect and that the business is worth more. One way to close the gap is for the broker to propose that the seller consider an earn-out to entice a buyer. Admittedly, this approach requires both that the gap not be too extreme and the seller to be reasonable (the latter of which is not always the case).