Selling a Business: The Earn Out
22 November 2021: Selling a Business/The Earn Out
When selling a business, an earn-out refers to a pricing or financial structure of an acquisition whereby the sellers must “earn” part of the purchase price, usually based on the performance of the business for a certain period of time following the acquisition.
As a rule, earn out provisions that are components of an acquisition agreement are generally found in the section describing the purchase price and the method the purchase price will be paid. An earn out is a subsequent and usually varying aspect of the purchase price, the amount and payment of which is determined by the future results of some aspect of the company’s performance – usually the earnings of the business being acquired.
When selling a business, an earn out gives the seller an opportunity to achieve a higher valuation.
Why an Earn Out?
At the heart of every business acquisition is the value of the company being acquired.
In the event, the parties in any acquisition generally – and not surprisingly – have different opinions about the valuation of the target company. How the parties negotiate a price based on their respective sense of that value – as well as how that price will actually be paid – is the crux of the negotiations.
As we discuss in our Course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, and during our coaching of Realtors and budding business brokers in how to value and sell businesses, it has been our experience over the past 20 years that most business owners have an exaggerated opinion of the value of their business.
Buyers, on the other hand, often view a business with an overabundance of skepticism.
So, how is that chasm bridged?
We first have to understand what is being valued – and that might differ depending on how large or complex the business is or how sophisticated the parties involved.
In a financial acquisition, a business is often valued based on the answer to the question, “How much money will this business put in my pocket?” Strategic acquisitions are different but that’s a topic for a future discussion.
Businesses are sometimes valued based on their historic earnings; that is, what they have generated over the past three to five years. But many larger businesses – and businesses with recent significant developments that are expected to increase their earnings trend – are valued based on anticipated earnings; i.e., what they’re expected to generate over the next few years.
The buyer and seller are likely to differ in their estimate of projected earnings. And there are countless, impossible to foresee issues that can occur – both fabulously positive and catastrophically negative – during the earn out period that can impact those projected earnings.
Earn outs are generally used when there is a difference in the value of the earnings projected by the buyer and seller. An earn out can allow a seller to be paid for the negotiated value of those future earnings.
Let’s look at a couple of situations when an earn out might be used.
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Seller’s Price Expectation
The aforementioned difference of opinion of value is an obvious one.
The seller believes the business, due to a contract she is about to sign with a new client or customer, will increase annual growth over the next five years to 15% from 10%.
The parties could agree that the buyer would pay a base price based on a valuation determined by the historical earnings of the business but, if the business enjoys the additional growth projected by the seller, the buyer would paid more. The acquisition agreement would be structured so that, if certain milestones or targets are reached or exceeded, usually on some agreed-upon schedule, the purchase price would be increased in ladder-like fashion and the seller is entitled to additional payment. This arrangement can continue for several years.
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A related situation is where a compromise would allow the parties to bridge their different expectations with regard to the valuation of the target company and thus avoid the monumentally undesirable result of the entire transaction heading into the toilet.
Pros and Cons
The main advantage of an earn out for a seller is that he or she can benefit from and participate in any positive economic developments experienced by the acquired business. This is particularly true when the business being acquired is likely to benefit significantly by some technical, geographic or contractual development.
Of course, one of the downsides of an earn out is that the seller has to stick around during the earn out period to make those “positive economic developments” happen.
Examples of such positive developments could include the acquisition of a license to distribute some specialized product or the in-house development of a unique technology. A geographical example would be the announcement of plans to construct 400 apartments across the road from the convenience store you want to sell. A contractual example would be an agreement to supply product to 20 Walmarts or to supply technical or advisory services on a recurring revenue basis to a new client.
A potential danger for the seller is that, post closing, the seller likely has little or no influence on the decisions made about the direction of the target company – the business the seller just sold. The further development of that business now depends to a large extent on the decisions made by the buyer.
In theory, the buyer could deliberately frustrate the seller’s attempts to reach the agreed milestones and targets for any earn-out to benefit the seller.
But even without any intent to derail the seller’s attempts to reach the agreed earn out milestones and targets, bad decisions made by the buyer could certainly frustrate the seller’s attempts even if the earn out goals would have been achievable.
This downside can be mitigated to a certain extent by the seller assembling the proper advisors, including a transaction attorney – not a divorce or speeding ticket attorney; and especially not a personal injury lawyer more accustomed to chasing ambulances for clients. When selling a business – even without an earn out clause – acquisition document language is crucial.
For the buyer, an earn out can significantly reduce – or even eliminate – the risk of overpaying for the acquired business. It can also act as “collateral” for the warranties, representations and disclaimers made by the seller and memorialized in the acquisition agreement.
Downsides for the buyer include possible restrictions on how the buyer manages the acquired business, particularly if certain unforeseen events impacting the business should occur or opportunities arise during the earn out period.
For example, let’s say that the earn out term is for a period of five years. That is, the seller has five years to incrementally earn a high purchase price. If the buyer is is approached in year three by a larger company or a private equity firm, and the terms of the original acquisition agreement don’t anticipate the possibility of the buyer “flipping” the business, the seller may end up losing the opportunity to gain additional value from an earn out.
Again, the language in the acquisition document is crucial.
The Bottom Line
In any earn out, the seller will have to stay on with the business and affect the positive results that the seller claims will happen. The seller is, after all, “earning” the additional value.
But earn outs are often challenging aspects of an acquisition agreement to negotiate simply due to the fact that there are almost endless potential scenarios that can play out over the first few post-closing years. As you can imagine, the proper legal talent is critical.
There is much more to discuss about earn outs and we’ll revisit this topic again soon. But when selling a business, our clients need to be aware of this option as a way that has the potential to allow them to capitalize on their business’ future growth.
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.
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I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.