What is an Earn-Out?

By Generational Equity


I believe we have yet to meet a client who at the outset of our engagement with him/her doesn’t tell us that they want an all cash deal. While we understand this goal, especially for those who are ready to move on to another phase in their lives, it is important to consider that sometimes a seller can actually earn more on the sale of the business via quality deal structuring.

One such method is known as an “earn-out.” One of the best descriptions of an earn-out comes from our friends with Axial, an organization dedicated to helping capital providers meet folks needing investors. Here is their description:

An earn-out is a common way to bridge the gap between a seller’s expectation of business value and a buyer’s willingness to pay. Earn-out structure varies, but the basic idea is that a buyer will make additional payments to a seller post-close, dependent on the business achieving certain goals.

Based on this description, you can see that the risk to the seller can range from very low (if the seller stays with the company as CEO post sale to help the goals be reached) to very high if the seller is unwilling to remain and trusts that new owners will be able to run the operation efficiently and effectively after his/her departure.

Of course the other key variable are the levels of revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) found in the projections the seller provides to the buyer. As we always counsel our clients, it is far better to create projections that can be achieved in case there are any contingent payments as part of the final deal structure. It is preferable to create realistic forecasts than develop unrealistic ones and not hit them. And, odds are good that if your revenue has been growing 5% annually for five years and you suddenly project an increase to 20% per year, most buyers WILL require an earn-out to ensure that these numbers are hit.

To prevent the need for an earn-out and to ensure that 3-5 years down the road you receive all your contingent payments, it behooves you to create credible forecasts.

What is Best for You?

Any form of deal structure is dependent on your needs as the seller. You need to analyze your personal situation and determine, as much as possible in advance of creating any deal, how long you want to be retained in the new company. Of course most of the time what an earn-out also revolves around is how “buyer ready” the business is when you depart. If you make 100% of the daily decisions, a new buyer will likely have some contingencies tied to the deal. If you don’t have a middle-management team in place, many buyers will attach risk to your departure and will most often have contingent payments involved.

However, if there really is genuine upside for your business and what you lack is capital and bandwidth for growth, then an earn-out can certainly fill the gap in what your valuation is today vs. what a buyer will be willing to pay today for your future.

These are issues that you need good M&A advice on and that is why we recommend that you hire an M&A professional to guide you. If not, you may agree to a structure that truly benefits the buyer, not you. Don’t end up in that situation.

To learn more about earn-outs and the myriad of other deal formats in use today, I recommend attending a Generational Equity M&A seminar. These are designed to help you learn as much as you can before you engage any buyer. To learn more about our typical agenda, follow this link or call us at 972-232-1121.

By Carl Doerksen, Director of Corporate Development at Generational Equity.

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