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How to Earn Your Earn-Out

By Generational Equity

12/14/2020

As we have highlighted in past posts, the creation of an “earn-out” to structure your exit can be a fundamental way to generate a significant return on your exit. However, if not structured wisely, it can also be a way for you to leave significant capital behind you.

How can you know the difference?

The best way is to hire a professional exit planning firm to represent you and protect your interests. If you don’t go that route, then you will need to be quite savvy and create an earn-out that protects you.

Our friends at Axial recently published an article on how to create an earn-out that protects and benefits you, because one of the basic tenants of any earn-out agreement is shared risk. The buyer shares the risk with you that the continuity of the company is ensured upon your eventual exit.

Entitled “The Fastest Way to Earn Your Earnout”, the article is full of great advice for those contemplating an earn-out structure.

In summary, they analyze the Pareto Principle. This is the concept that the economist Vilfredo Pareto established in 1906: The 80/20 rule. The 80/20 rule says 20% of the effort generates 80% of the reward. Think about that for a moment…

Where in your business does the greatest reward come from?

Analyzing your client base is critical in any earn-out equation. But you have to dig deeper than just customer concentration issues. As the folks at Axial put it:

The 80/20 rule in the B2B space is pervasive, but too often buyers and management teams think of concentration simply in terms of revenue by customer. What strategic buyers realize is that there is a much more strategic way to think about concentration, and that is by looking at the relationship between customer and product/service concentration.

Simply cutting customers or products and services without understanding the dynamic between the two will often do more harm than good. For example, your largest customer may buy your least profitable product, but without that product in the portfolio they establish a relationship with a competitor, risking wallet share.

I know that is quite a bit to chew on, but it is the question every seller must consider when even considering an earn-out with a buyer: Who gets the reward post-acquisition? How do you, the seller, ensure that your “high value” clients stay with your firm when you are gone? How does the buyer ensure that the clients who really create the most profit and/or have the most loyalty stay after you depart?

These are the hard questions that every earn-out has to answer. 

Have you ever done a deep dive into your client base? Not just to examine which clients are more profitable but also which ones are most loyal? And who are they loyal to? You the owner of the business or the company?

These are the salient questions that savvy buyers will ask of you during due diligence, and especially so if an earn-out is part of the equation. You must likewise examine them closely because if an earn-out is dependent on your 20 top clients being retained and they are all loyal to you personally, your earn-out could be similarly affected!

We know that these are not easy questions for business owners to ponder. But the stark reality is that you will be forced to examine them by buyers during due diligence – probably the most difficult part of the exit journey.

Because of this, we highly recommend that you have experienced exit planning advisors by your side long before you even consider an exit. This will not only protect you financially, it will help you grow your business STRATEGICALLY. Realize that there are ways to grow your business that build its value and others that have the opposite effect.

Knowing the difference from the viewpoint of a buyer is key.

The question is how can you learn to think like a buyer when you run your business on a daily basis? The tactical and strategic decisions you make this week, could have a big impact on the valuation of your business five years down the road.

Fortunately, we have a place for you to start your learning process. The Generational Growth and Exit Conferences have been designed to help business owners quickly and efficiently develop the tools necessary to not only think like buyers, but to understand the key decisions that need to be made on your journey to enhance your company’s value. 

To get started on your learning please use the following links:

And above all else, realize that in our current pandemic impacted world, the level of perceived risk has gone up on the part of all buyers. Earn-outs are becoming more and more useful as a way to share risk. Because of this, it is vital that you protect your interests!

Carl Doerksen is the Director of Corporate Development at Generational Equity.

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