5 August 2024: Selling a Business Using an “Earn-out”
Back in January, the subject of our post was so-called “earn-outs”, a method used in any number of situations when, in the course of selling a business, negotiations between sellers and buyers arrive at an impasse. That post was an overview.
In our weekly “Office Hours” in The Brokers Roundtable℠ – as well as our weekly Pro Sessions for brokers and Realtors taking our courses – earn-outs are a steady topic of discussion.
WHAT WE’RE LOOKING FOR: Food Service; Restaurants B2B Food & Beverage Manufacturing, Multi-location Consumer Services, Restaurants (chain, franchise). EBITDA: $5+ million. Location: U.S.-based
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“How are they structured?” “How long do they last?” “What metrics are used?”
These and other relatedly questions are raised on a regular basis. So, we thought that expanding on that earlier post – diving a bit deeper – would help.
First, What is an “Earn-Out”?
An earn-out is a financial arrangement commonly used in business acquisitions where the seller receives additional payments based on the future performance of the business.
An earn-out is used in an effort to align the interests of the buyer and the seller by bridging valuation gaps, mitigating risk and keeping a seller with unique knowledge or relationships involved and incentivized.
Earn-outs are particularly useful in situations where there is uncertainty about the business’s future performance or when the seller believes the business has strong growth potential that is not fully reflected in the initial sale price.
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While each situation is different, earn-outs generally share a similar structure and involve comparable components.
Structure of an Earn-Out
An earn-out typically involves a combination of an upfront payment and contingent future payments; the operable word being “contingent”.
Unlike future payments as part of some seller financing vehicle, the future payments stemming from an earn-out are tied to specific performance metrics the business must meet. These metrics can include revenue, EBITDA (earnings before interest, taxes, depreciation, and amortization), adjusted net income, or other relevant financial indicators.
The earn-out period usually spans one to three years, but it can be longer depending on the agreement between the buyer and the seller.
The choice of performance metrics is crucial in structuring an earn-out. These metrics must be clearly defined, measurable, and aligned with the business’s operational and financial goals. When selling a business using an Earn-out, common performance metrics include:
- Revenue Growth: Earn-out payments based on revenue growth incentivize the seller to focus on increasing sales. This metric is straightforward but does not account for profitability.
- EBITDA: Using EBITDA as a metric balances revenue growth with cost control, reflecting the business’s overall profitability.
- Net Adjusted Income: This metric includes all expenses and income streams, providing a comprehensive view of the company’s earning power and financial health.
- Customer Retention: In some cases, earn-outs are tied to customer retention rates, which is particularly relevant for businesses with a subscription model or long-term contracts.
- Milestones: Specific milestones, such as launching a new product or entering a new market, can also be used as performance metrics.
Advantages of Using an Earn-Out
One of the more obvious and oft-cited reasons for using an earn-out is that it can be a reasonable way to arrive at an agreeable valuation.
Earn-outs are effective in bridging valuation gaps between the buyer and the seller. If the seller believes the business is worth more than what the buyer is willing to pay upfront, an earn-out allows the seller to prove the business’s value through future performance. This arrangement can facilitate negotiations and make the deal more attractive to both parties.
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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. 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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Earn-outs incentivize the seller to stay engaged with the business post-sale and focus on achieving specific performance targets. This can be beneficial for the buyer, especially if the seller has unique knowledge, skills, certifications or relationships that are critical to the business’s success.
For buyers, earn-outs mitigate the risk of overpaying for a business. By tying part of the purchase price to future performance, buyers can ensure that they are only paying for proven success. This is particularly important in acquisitions where there is uncertainty about the business’s future prospects.
Challenges of Earn-Outs
Earn-outs add complexity to the sale process. The terms of the earn-out must be clearly defined, including the performance metrics, measurement periods, calculation methods, and payment schedules. This requires detailed negotiation and documentation, which can increase legal and administrative costs.
Disputes can arise over the interpretation of earn-out terms, the measurement of performance metrics, and the calculation of payments. To minimize disputes, it is essential to have clear, unambiguous language in the earn-out agreement and a well-defined process for resolving disagreements.
Post-acquisition integration can impact the performance of the business and, consequently, the earn-out payments. Will the seller, whose eventual total sales proceeds depend on how well the business performs over the earn-out period, have enough freedom and control to have realistic chance of meeting the earn-out targets?
Selling a business often results in changes in management, operational disruptions, or shifts in strategic direction can affect the seller’s ability to meet earn-out targets. Both parties must consider how integration will be managed and its potential impact on the earn-out.
Earn-outs have accounting and tax implications that need to be carefully considered. For example, earn-out payments may be treated as compensation for the seller, subject to ordinary income tax rates, rather than as part of the purchase price, which might be subject to capital gains tax rates. In general when selling a business, competent advisors are important. When using an earn-out to make the deal happen, it’s crucial to consult with accounting and tax professionals to understand and plan for these implications.
The Bottom Line
When you’re selling a business, earn-outs provide flexibility in deal structuring. They can be tailored to fit the unique circumstances of the business and the goals of both the buyer and the seller. This flexibility can lead to more creative and mutually beneficial deal structures.
But thoroughly considering all aspects of an earn-out and then constructing agreements to minimize, if not eliminate, vague but highly consequential language means that the importance of competent counsel when using an earn-out cannot be overstated.
And finally, if you’ve gotten this far, you know that the seller stays on with the business for at least the earn-out period. If the seller has already paid the entry fee required for an America’s Cup challenge, an earn-out might not be the solution to any of the issues raised above. But in many cases, the potential payoff is worth the additional time spent in the trenches.
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
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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