What Are Earn-Outs?
In the world of mergers and acquisitions, determining a company’s value is not always straightforward. Factors such as future growth potential, market conditions, and historical performance can make the valuation process complex. Often, sellers and buyers find themselves with a valuation gap when it comes to agreeing on a final price. However, that difference doesn’t have to bring negotiations to a standstill. In many cases, an “earn-out”—a flexible financial agreement—can bridge the gap and bring both parties to the table.
What is an Earn-Out?
In a standard acquisition, the buyer and seller agree on a fixed purchase price, and 100% of the funds are transferred to the seller when the deal is closed. This flat sale price is a result of both parties reaching a consensus on the business’s value and future outlook much earlier in the acquisition process. However, an earn-out introduces a different structure to the deal.
With an earn-out, part of the total sale price is contingent upon the future performance of the business post-acquisition. Instead of the seller receiving all the proceeds upfront, a portion of the compensation is tied to achieving specific financial milestones or targets over a set period. These goals could be directly tied to revenue, profitability, or other operational metrics. Essentially, an earn-out offers the seller additional compensation if the company meets or exceeds performance goals after the sale is completed.
When Should I Consider an Earn-Out?
Earn-outs can be particularly advantageous in specific scenarios, and it’s worth considering if certain conditions align with your goals.
If you intend to stay on with the business post-acquisition
Earn-outs are appealing to sellers who plan to continue working in the business after the sale. As the seller, your ongoing role provides the opportunity to directly influence the performance of the company, increasing the likelihood of hitting targets that would trigger future payouts.
If you expect the business to grow
Many business owners believe that the future holds significant growth opportunities for their company. In such cases, an earn-out allows you to benefit from that anticipated growth. Unlike a flat sale price, which locks in your compensation at the time of sale, an earn-out gives you the potential to earn more if the company performs well post-sale.
If you want to maximize your earnings
While the upfront payment in an earn-out may be lower than in a traditional flat sale, the earn-out structure offers the possibility of greater total compensation. If the business exceeds expectations, the additional payouts could significantly increase the overall sale price, making it a lucrative option for sellers who are confident in their company’s future.
How Are Earn-Outs “Earned”?
Earn-outs are typically tied to the performance of the business after the sale. The buyer and seller agree on certain milestones or targets that must be achieved for the earn-out to be “earned.” These targets often focus on financial metrics such as revenue, net income, or EBITDA (earnings before interest, taxes, depreciation, and amortization). The duration of the earn-out period and the payment terms are negotiated before the sale, often covering a span of one to three years.
At the end of the agreed-upon period, if the business has met the performance targets, the buyer will make additional payments to the seller. For example, if the agreed milestone is reaching a revenue target of $10 million within two years, the seller will receive the additional payment only when and if the business hits that goal. Both parties negotiate these terms during the pre-sale phase, ensuring clarity on expectations and payment schedules.
Conclusion
While earn-outs aren’t suitable for every business owner, they can be an attractive option for sellers who are considering remaining in the business and capitalize on its future success. For those looking to stay on post-acquisition or who believe their business has strong growth potential, earn-outs offer the chance to maximize earnings beyond the initial sale price.
If you’re considering selling your business, it’s worth discussing an earn-out structure with your broker or potential buyer to see how it could benefit both parties. The flexibility of an earn-out could provide you with an opportunity to secure a more favorable deal while aligning the future success of the business with your financial interests.
