15 January 2024: Selling a Business: Earn Outs
If you own a business of a certain size – or broker such businesses – are you familiar with the most salient intricacies of an “earn out”? If not, you should be because, in certain market environments – such as the one we’ve been in for the past couple of years – we’ve seen more of them.
Over the past few years we’ve occasionally written about earn outs but those discussions were at a general level. Given some recent activity, a bit of a deeper discussion is in order.
Earn outs can be – and often are – quite complex. This post is intended to offer insight into some of the key aspects of an earn out. A follow up post may be warranted.
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What’s Driving the Use of Earn Outs?
Two things are nominally responsible – inflation and interest rates – but there’s plenty of finger-pointing.
Some advisors also point at the increased cost of energy, labor shortages spawned by government policy that increases the disincentive to work, supply chain problems, the instability of global relations – made woefully apparent in Ukraine and the Middle East – and the ongoing, in fact increasing dysfunction of government.
All of these alleged problems boil down to an increasing inability of buyer and seller to agree on a business’ value – the transaction price.
Sellers, if they’ve been aware of the value of their business over the past 3-5 years, often have a preconceived number in mind. But that number is generally based on the economic environment that existed prior to interest rates and inflation starting to climb. Buyers, intent on finding a business that can deliver a certain return on their investment, have become more cautious and conservative, afraid of over-paying for a business. These two viewpoints often prevent the parties from reaching an agreement on value.
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Courses! Courses! Courses!
Many of you have asked if our Flagship Course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, could be made available on a module-by-module basis. Instead of enrolling in the complete course, could you enroll only in the module(s) you wanted? We’re happy to report that this is now possible.
We’ve broken our Flagship into six separate modules (or module groups) to give you all the flexibility you need to learn only what you want to learn – and we’ve moved them all over to the new Brokers Academy in The Brokers Roundtable℠ . The Flagship is still available but the modules are now available individually.
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What is an Earn Out?
About a year ago, an article came across our desk that contained an excellent definition of an earn out. (Unfortunately, we’ve lost the article and are unable to give proper attribution.) It stated:
“An earn out is a form of contingent, deferred consideration that is often utilized to reconcile a difference of opinions between the buyer and the seller regarding the fair market value of the target business as of the date of the closing.”
By way of general example, the acquisition agreement will state what is essentially a minimum value agreed to by both parties and a provision for that number to be adjusted higher based on an agreed upon formula applied to the actual earnings of the business over a defined number of years after the closing of the transaction.
Any additional amount payable to the seller would be due only if the business’ performance goals were reached.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
An earn out provision could, of course, be structured so that the performance goal(s) and additional value owed to the seller are essentially moving targets rather than an “all or nothing” approach. If the performance goal is a 10% annual earnings increase for the three years post-closing but the actual increase in less – or more – the best formulae would calculate an appropriate adjustment in the purchase price.
Using a well-crafted earn out insures that the buyer doesn’t overpay for the business but also insures that the seller receives the actual value of what he or she has built; value that was not accurately accounted for in the agreed upon sale price.
The Bottom Line
Earn outs are less likely to be encountered in the Main Street market – businesses with valuations of less than US$1 million – than in the lower Middle Market. But they do happen. Understanding how they work – and, for business brokers, being able to explain the process to our clients – is an important aspect of managing the client’s expectations.
There is, of course, more to earn outs that outlined here. One of the most significant aspects is how earn outs are handled is tax impact. We’ll tackle this in an upcoming post but if you have questions in the meantime, I’d suggest contacting Mike Gartman, CPA, a member of The Brokers Roundtable℠.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at jo*@Wo*******************.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at jo*@Wo*******************.com