An earn-out is when part of the consideration received for a business is based on future sales or earnings. Earn-outs usually come in to play in business acquisitions when a business has high risk factors, or when non-linear growth is reasonably expected, or when there is a significant gap in the price expectations between the buyer and seller. In all cases the parties share the risk and reward of future performance.
Bridging a Price Gap
An earnout is often the best way to bridge a gap between what a seller will accept and what a buyer will pay. For example, a seller may think their company is worth $4 million and the buyer thinks it’s worth $3 million. They can agree on a guaranteed price of $3 million, plus an earn-out over a period of 1-2 years, structured to provide the seller with the potential of receiving the extra $1 million, or more if sales or earnings reach a certain level, based on an agreed upon formula.
Devil in the Details
While simple in concept, earn-outs can become contentious during the measurement and payout phase. It is critical that earn-out parameters be carefully thought out and clearly defined in the purchase agreement. There must be no ambiguity in the accounting practices to be used, for example. Even if you continue to manage the business during the earn-out period, don’t assume anything.
At the same time, remember the K.I.S.S. principle. In my experience, the more complicated an earnout gets, the more likely negotiations will fail. It is usually (though certainly not always) best to base earn-out calculations on top-line sales or gross profit, not net income. Also, be sure to design the earnout formula to completely align the interests of the parties.
For another perspective on the use of earnouts in M&A transactions, see this recent article on Axial Forum.
For more information on M&A transaction structuring strategies, or if you want help selling a business or developing a winning exit strategy, contact me at 707-778-2040 or firstname.lastname@example.org.