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.

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