All About Earn-Outs

Posted on March 7, 2007

A purchase agreement in which the seller receives more if certain benchmarks are met by the buyer in the years following the sale is called an “earn-out”.  Such devices hold the promise of giving the seller more from their sale over time, or setting performance standards for the buyer. But they’re tricky, unpredictable, and may poison the relationship.

Nobody knows what the future holds. Nobody. What has happened in the past can help to understand what the future may hold, but it is no guarantee. Throw in to the mix a change of ownership of a business, and there is even more reason to worry that the future will be different from the past.

This issue is at the crux of valuing any business being sold. The buyers of the world are investing money in hopes of getting a good return in the uncertain future. What happened in the past won’t do them any good.

The sellers of the world have worked hard and have created a track record documenting the viability of the business over time. They want to get a fair return for all that hard work and investment over the years.

When earn-outs come into play, both positions are correct and fair. But the price of the business, as figured by buyer and seller, usually comes out with a gap. Part of the gap can be offset by unequal eagerness on the part of the seller and buyer. In other words, a buyer who really wants to buy will get more generous, or a seller eager to sell backs off a bit.

When they are still apart, an earn-out is often a solution. In short, an earn-out is a payment made only if a certain condition is met. For example, if sales in year 2 really do hit $22 million, then the seller will be paid an additional $2 million.

Yes, the sellers should feel uncomfortable with earn-outs. And the buyers will be happy to offer them. Sometimes if you want the deal consummated, you have to accept some portion of the price being an earn-out.

Here are some really important considerations.

1. What portion should be an earn-out? Certainly if the seller is claiming big hockey-stick growth in the future, he can’t expect to be paid guaranteed dollars for that. An earn-out seems fair. But earn-outs are very risky, and are often not paid for a variety of reasons. Only a high-risk future should be offset with earn-outs.
2. Earn-outs are based on conditions, and those conditions must be defined very clearly. This is a huge, very troublesome matter. Defining them by net sales sounds easy, but what if the new owners cut the product development budget by 50%? They’ll have the right to do it and not pay the earn-out—unless you’ve put in the contract an agreed amount to spend on product development. Earn-outs based on EBITDA or net profit are horribly contentious calculations. What if you—the seller and agreed-upon CEO of the business after the sale—are fired? Do the earn-outs then pay immediately? The variables go on and on. Think them through carefully and with an experienced dealmaker, lest everyone enrich lawyers after the fact.
3. As a seller, if you never get your earn-out, how will you feel?
4. As a seller, have you bargained your hardest to minimize the earn-out? Fixed guaranteed payments over time are much more secure than an earn-out (but still not nearly as secure as cash on the barrelhead). Can you shift some earn-out to fixed payments?
5. Have you carefully researched the buyer’s historical performance on earn-outs promised to past sellers?

If the business you are selling is strong, with excellent past performance (from an independent point of view), then you should insist on a large guaranteed amount for the business, with a little upside above the base as an earn-out. On the other hand, if your performance has been mixed and the buyer has offered a fixed amount that is too low for you, then look at an earn-out as a possibility to make up some of the difference.

Be assured that earn-outs often cause ill will between the seller and the buyer over time. There are just so many things that can go wrong or can be viewed from different perspectives. If having a good relationship with the other party is important post-sale, work really hard to avoid or minimize earn-outs.

Of course, relative power trumps all. If you’ve just got to sell, you won’t have much ability to affect the outcome. Just the same, if you’ve got to buy, you’ll surely end up overpaying.

Takeaways:

• From the seller’s point of view, earn-outs are not very good and are a risky way to be paid for your business. From a buyer’s point of view, it’s a good tool to bridge the gap between the value of what the seller says will happen and what actually happens.
• Be sure to clarify the rules around the earn-out, keeping in mind that the buyer would rather not pay the earn-out, and the seller really wants the earn-out.
• If maintaining a good relationship between seller and buyer after the deal is done is important, try and minimize or eliminate the earn-out.