What is an Earn-out?

Disagreements emerge in any negotiation. For transactions in the middle market, the friction is typically around price.

Despite months of negotiation, buyers and sellers often have trouble agreeing on a specific purchase price. But this disagreement does not need to end the entire process. Rather than scrapping the transaction, one strategy to bridge the gap between the buyer and the seller is to use an earn-out.

With an earn-out, the buyer makes additional payments to the seller, after the sale, dependent on the performance of the business and the owner’s involvement in the business. Earn-outs are essential to closing deals when the buyer and seller just can’t agree on an exact price. They are designed to protect both parties and ensure that everyone receives fair value for the business.

Let’s take a deeper dive into some of the specific advantages of an earn-out agreement to business owners:

• Shorten the negotiation time. Rather than haggling over price for months (and potentially never reaching an agreement), an earn-out can speed up the process of selling your business. Since each party is essentially “agreeing to disagree,” the earn-out can restart stalled processes. This can drastically reduce the efforts and headaches associated with selling your business, lead to a better relationship with your acquirer, and potentially reduce some of the fees related to a M&A transaction. However, earn-outs do require some negotiation themselves.

• Get full value for your business. An earn-out allows you to receive the full price for your business post-acquisition, because you don’t rush to sell in one payout. Instead, earn-outs can act as a form of dividend payment. If the business performs stronger than the buyer anticipated, there is a likelihood that the sum of the earn-out will exceed the one-time payout you would have received at the time of the negotiation. This is particularly true if you are selling a strong business in a down market — the earn-out can get you closer to what your business might be worth in a strong market.

• Ensure a seamless transition. During an acquisition, an abrupt departure by the owner can create some cultural uncertainty. Employees are uncertain about the future of their roles, the company, and their future. In an earn-out, you are typically remain involved in the company during the transition and have the ability to include key employees at your company in the loop. Rather than leaving your top workers shocked and disgruntled, you should include the smooth and successful transition of your most loyal people that have been with you from the start.

• Demonstrate confidence to the investor. Earn-outs are appealing to an investor because they prevent the firm from overpaying for the company since the earn-out is only paid when the company exceeds pre-defined performance thresholds. By agreeing to an earn-out, you demonstrate that your are very confident that your business will outperform their conservative estimate. This confidence can be a good sign to the potential investor, indicating you are not hurrying to jump from a sinking ship.

While the exact terms of the contract can vary, it is estimated that 25% of M&A transactions in 2013 included an earn-out. The average length of the payout was 12 months, but 21% lasted longer than 36 months.

Before committing to an earn-out, be sure it is the payment structure you really want. If there is a significant difference between your price and the buyer’s price, it is important to consult with your M&A advisor and make sure you are not overly confident about your price. Also work with your advisor to create a graded earn-out structure, so your payment is relative to actual performance — you don’t want to get 0% of your earn-out for just missing the target.

Recent research also reports that 40% – 45% of a payout can come through the earn-out. As a result, it could be years before you realize the full payout of your transaction and mean a reduced initial payment. If you are looking to exit in a hurry, an earn-out does not make sense.