What an Earn-Out is & How to Structure a Deal that Includes One

By Generational Equity

11/17/2014

There are a number of ways that the sale of a business can be structured. 100% all cash deals are rare. In most cases, deals are created where a combination of cash, financing, stock, and/or earn-outs are used. The key to any structure is ensuring that it protects your financial legacy and is set up so that you are able to close an optimal deal with a premium buyer. In this piece we will examine typical earn-outs and their features.

According to Investopedia, the definition of an earn-out is:

“A contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals.”

The official Generational Equity definition is similar:

“The portion of the purchase price that is contingent on future performance. It is payable to the sellers only when certain predefined levels of sales or income are achieved.”

According to George Geis, an associate dean of the Executive MBA Program at UCLA's Anderson School of Management, in an Inc.com article from a few years ago:

"An earn-out is a contingent payout, which essentially involves shifting some of the purchase price to be paid in the future on the realization of future earnings or some other benchmarks of success. So the owner needs to be willing to delay some of the price, and be aware they might never get it."

I have highlighted similar key points in the passages above to illustrate one of the critical features common to all earn-outs: They are tied to the future performance of the acquired company POST-acquisition. As such, there is tremendous upside (and downside) to an earn-out structure.

Christine Lagorio-Chafkin, a senior writer with Inc., expands on these definitions and makes an excellent point regarding the risk of an earn-out to a seller, as well as the potential benefits:

“A common feature of many acquisitions, an earn-out stipulates that the original owners of a business are paid for the sale of their company, following which they are contractually obligated to stay with the company through a transition period, and they are provided with the incentive to have a demonstrable effect on the company's financial performance going forward. Achieving or exceeding a certain level of performance – criteria are typically set over a period of several years – means the original owners will earn a much larger profit from the sale.”

Two Key Concepts

So two things that we encourage all of our clients to consider as we work with them to create their five-year pro forma that will be used by buyers to determine the value of the company:

1. Be HONEST with yourself about the TRUE potential growth of your company – avoid the hockey stick method of forecasting.
2. Plan on working just as hard, if not harder, after the acquisition if you structure an earn-out for your business.

Both of these are equally important and need to be carefully considered by any business owner before approaching a buyer. Keep in mind that quite often an earn-out of 2-3 years time will generate MORE for you than simply selling the company and walking away from it. As we have discussed before, the one common trait that all buyers have is an aversion to risk. An earn-out is a great way to bridge the gap between what you believe the company can do going forward and the concern a buyer might have about it not coming to fruition without your involvement.

The most important first step is to work with your M&A advisor to create a five-year projection of your company’s recast financials that are defendable, are achievable, and – most importantly – do not raise concerns about the veracity of all your documentation. For example, if your company's historic compound annual growth rate of revenue and earnings is 5%, forecasting this to improve throughout the next five years to 30% is going to do more harm than good.

And, if you do find a buyer that is willing to talk to you about acquiring your business, a good portion, most likely 30-50% or more, will be “contingent.” So if your projected growth instead of hitting 30% is half or less, so too will your future payouts. You never want to fall into that trap, working really hard for an additional three years post-close and not reaching your ultimate valuation target. It can really lead to disappointment and bitter feelings. And don’t expect the new owner of the company to feel sorry for you and revise the structure of the deal. That is not likely to happen!

Which leads us to the second point: You are going to have to continue working hard to make your projections a reality. Far too many sellers ASSUME that simply because you are no longer shouldering 100% of the risk of running the business, and that you now have a new boss to help make key decisions, that the level of time committed to the earn-out will be less than was required to run it when you were the sole owner. That is rarely the case. If you are working with a skilled M&A advisor, he or she will work hard to stipulate what your new role will look like and what you will be directly responsible for during the earn-out period.

Make sure that any earn-out you negotiate is clear regarding what targets will need to be reached going forward AND what your role will be in helping to achieve those goals. Typically earn-outs combine some form of revenue and earnings growth. Ensure that your agreement with the buyer is clear regarding what those milestones will be AND what you will be doing to achieve them.

For example, if your goal is revenue growth of 10% during the next three years and net profit improvement from 10% to 15% during the same timeframe, then make sure that you have the ability, in your new role, to make both happen. Far too often we encounter business owners who have sold their businesses without an M&A advisor, using an earn-out structure only to realize far too late that the goals are not clearly outlined nor do they have the authority in their new role to make them happen. That is why working with an M&A advisor is so critical when selling your company. If they are experienced in structuring deals, they will work to ensure that any transaction will protect you and your financial legacy.

Who NOT to Set Up an Earn-Out With

A final thought: One earn-out structure that we recommend you avoid if at all possible is creating a contingent program that sells your business to either your employees or family members. The problems with an earn-out with either of these groups are legion. The most critical being that usually neither of these groups brings any capital to the table. Too often they will need to obtain a loan (with a high interest rate) or, worse yet, have you finance the transaction AND saddle you with an earn-out to boot. Then, overnight, no longer do you have employees but you also have partners – does that change the dynamics of the business!

This situation is even worse if you are selling to family members. Imagine Christmas dinner in the not too distant future where your offspring or siblings are several months behind in paying you your contingent payments. The tension as you share the eggnog could be cut with a knife. You want to avoid that at all costs.

To summarize: An earn-out is a legitimate deal structure quite often used by dealmakers to bridge the perceived gap between the value a seller sees in the future earnings of a business and the risk a buyer envisions with them. Caution must be used when creating forecasts that you present to buyers AND you need to be sure that you will have the motivation to work hard, or harder, with a new boss than ever before.

Can You Work Well With Others?

And this leads us to one final thought as well: Get to know your buyer as you go through due diligence. Ensure that you can work well with him/her because going forward, you will now have a new boss for the first time in years. The importance of this cannot be over stressed. If you are not comfortable with the style, substance, and nature of your buyer, then working closely during a 2- to 3-year earn-out may not be optimal.

If you would like to learn more about all forms of deal structuring, including earn-outs, I invite you to attend a Generational Equity M&A executive conference near you. An investment of a few hours of your time will yield tremendous growth in your understanding of the exit planning/M&A process and will protect you from making any bad decisions when you are negotiating with a buyer (assuming that you don’t have the services of an experienced M&A advisor).

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

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