Earn-Outs and Contingent Payments

Often, when buyers and sellers want to complete a deal but can’t agree on the price, they employ a strategy called an “earn-out.” An earn-out is a contingent payment that the seller only receives from the buyer when specific performance targets are met.

Why Earn-Outs Are Needed

As a seller, you know your business’s potential. Perhaps you’re introducing a new product that you’re confident will boost revenues. Or you can see that your marketing campaign is starting to gain traction with customers. As a result, you sincerely believe that this upside should be reflected in the selling price.
Of course all buyers are from Missouri – and have a “show-me” attitude toward predictions of future profits. Writing for Inc., Christine Lagorio-Chafkin points out, “it's commonly known that roughly three-quarters of all mergers and acquisitions fall short of the expectations that are stated when the deal is announced. And about half of all deals result in a loss of value for the buyer’s shareholders.”
In other words, buyers have a rational basis to be concerned about paying full price for growth potential.

Structuring an Earn-Out

The earn-out is a good way to hedge the buyer’s risk of overpaying. It also allows the seller to benefit, if and when the business’s potential materializes. The key factor to keep in mind is that you, the seller, will normally be expected to stay on board, running the company during the earn-out period. This could extend for several years.
That’s why the terms of your engagement during the earn-out period should receive close attention. Will you have autonomy as before? Will you be able to retain key employees? And will you control the budget? If you don’t have the proper tools, you may not be able to achieve the results you’re expecting.
You’ll also need a team of lawyers, accountants, and M&A consultants to negotiate the specific terms of the earn-out agreement. Foremost is the percentage of the selling price that will be allocated to the earn-out. In general, experts say that 40% is typically thought of as the minimum amount needed to keep the seller motivated.
Then you have to agree on the numbers themselves. Will the target be revenue growth, EBITDA (earnings before interest, taxes, depreciation, and amortization), or gross profit? Or will a specific event, such as the signing of particular contracts, signify that the goal has been met? Will there be milestones or annual increases in the growth figures? Who will compute the results? What accounting method will be used?
In addition, there are also tax considerations that affect buyers and sellers differently. And don’t forget dispute resolution mechanisms, including the terms for what happens when either the buyer or seller wants to exit the agreement earlier than the stipulated date.

How to Make Earn-Outs Work

Obviously, there’s a lot here for the lawyers, accountants, and consultants to sink their teeth into. However, experts advise that the best strategy for both parties is to try to keep the terms as simple as possible. Remember, during the earn-out period, you’ll be working as a partner (or possibly as an employee) of the acquirer. Thus, it’s in everybody’s best interest to focus on success, rather than on milestones and a maze of intersecting benchmarks.
Another key to success is for you to retain autonomy as CEO. As stated above, it’s essential to have the authority to make necessary expenditures, and to keep your key people working with you. Smart buyers will understand this. In fact, in many acquisitions, keeping the previous owner involved may be as important a part of the earn-out as the actual selling price. Of course, if the buyer wants to eliminate non-strategic redundancies – such as back office functions – there’s no reason to protest. In fact, it could help make your job easier.

Game Plan

If you’re interested in learning how earn-outs are negotiated, this read this article PDF by Fred Tannenbaum will give you an inside look at numerous actual deals. There’s a lot of detail about the different terms that are subject to negotiation, and what to watch out for. According to Tannenbaum, sellers should be careful about boasting too loudly about earning potential, as it’s a red flag for buyers’ lawyers to press for earn-out terms that force the owner to live up to those claims.
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