Earn-outs: A Necessary Evil in Business Transactions or a Valuation Bridge between Buyers and Sellers?

August 10th, 2017

Most business owners who are contemplating the sale of their business tell us they are vehemently opposed to a transaction structure that includes an earn-out component. When asked why, the typical answer they give is that earn-outs never materialize. They tell us a story about a friend who sold his or her business and was never paid the amount of the earn-out component. What is an earn-out and why do they exist in business transactions?

What is an earn-out? 

Wikipedia defines an earn-out as a “pricing structure in mergers and acquisitions where the sellers must "earn" part of the purchase price based on the performance of the business following the acquisition.” In essence, an earn-out enables a buyer to defer a portion of the purchase price to a later date, provided certain contractual obligations are achieved, thus reducing the financial risk associated with that transaction.

Earn-outs are often contemplated in the sale of service businesses where there is concern that revenue or EBITDA projections are not going to be achieved. According to S&P Capital IQ, over the past 4 years “between 15.8 and 20 percent of total deal flow was comprised of some form of an earn-out in deal value.”

Why do earn-outs exist?

Earn-outs are most commonly utilized in the sale of a business when buyer and seller need to bridge a valuation gap that exists. Most often the owner, or the executive team, will continue to operate the acquired business post-closing when an earn-out is utilized.

Earn-outs are most commonly incorporated into a business transaction for the following reasons:

  1. To lessen the buyer’s risk associated with the financial performance of the selling business post-closing.
  2. To incentivize the owner of the selling business to make sure the business performs post-close.
  3. To retain certain key employees of the selling business.
  4. To provide a level of protection for the buyer in cases where a concern exists that projections are overstated and not achievable.
  5. To take advantage of a creative form of financing when convention sources of funding are not available to the buyer.

We were involved in a transaction where the selling business was only in existence for eighteen months.  The leadership team of the selling business, however, had decades of experience running other businesses within this particular industry so the buyer was comfortable they would continue to perform although the business was still relatively young. The buyer paid a substantial amount of cash at closing to motivate the owners to sell after only eighteen months in business.

In addition, the buyer incorporated a multi-year earn-out tied to two components. First, the owner of the selling entity had to come to work to perform his duties. If he did not come to work, as defined in the employment agreement executed at closing, he would not have been paid a portion of the earn-out. Second, the selling entity had to achieve certain revenue and EBITDA goals that were spelled out in the purchase agreement. Reflecting back on this transaction, the owner showed up for work and the business performed as the seller forecasted. Thus, he was paid the full amount of the earn-out component of this transaction. Hiring an experienced transaction advisor and a deal savvy transaction attorney is essential to making sure the seller and buyer are protected especially when earn-outs are incorporated. To schedule a confidential call with one of our experts, contact us at hq@kaulkin.com.

Comments are closed.


Is Preparation Necessary Without Intent to Sell?

January 23, 2018

Are you prepared to sell your business, even if you have no intention of selling it any time soon? Circumstances can quickly arise that are completely out of your control, and being prepared will undoubtedly help you obtain the highest price and best possible deal terms.....

» see this post    » all posts

The ED Procurement Debacle: Decision Made?

January 18, 2018

The Department of Education has made a decision regarding the procurement process and has awarded two new contracts. What do the experts think? Mike Ginsberg sat down with Randy Kamm to discuss just that in this two part, highly informative podcast! ....

» see this post    » all posts

Can I Determine the Market Value of my Business Before Going to Market?

January 16, 2018

The decision to sell your business should not be taken lightly. Before you respond to the next inquiry from an unknown buyer and potentially turn your business upside down, make sure you have a thorough understanding of your company's value.....

» see this post    » all posts


Mike Ginsberg to speak at RMA's 2018 Annual Conference

January 9, 2018

Mike Ginsberg, president and CEO of Kaulkin Ginsberg, will be joining a panel of industry experts at RMA's 2018 Annual conference to discuss M&A and financing in the ARM industry.....

» see more

Kaulkin Ginsberg Company announces the addition of the U.S. federal government market segment on KG Prime.

December 5, 2017

As part of Kaulkin Ginsberg expanding market intelligence series on KG Prime, their market research team recently retrieved and examined data regarding the US federal government market segment.....

» see more

Kaulkin Ginsberg Company Teams up with Topline Valuation Group to Offer a New Valuation Service

November 21, 2017

Kaulkin Ginsberg, in conjunction with its sister company Topline Valuation Group, announces the release of a product that provides ARM company owners with an in-depth assessment of their company's strategic opportunities.....

» see more