Earn-outs have become an increasingly common feature in M&A transactions, as valuations have continued to rise in recent years. In very simple terms, an earn-out is a provision in an M&A purchase agreement whereby a buyer may be obligated to pay additional consideration to the seller if certain performance metrics or business milestones are met following the closing.
When used properly, an earn-out is a great way to bridge a valuation gap between what a buyer thinks a business is worth, and what the seller believes it is worth. It gives the seller the opportunity to “prove it” when they believe the business is worth more than a buyer is wiling to pay at closing. If a seller will continue as an employee following the closing, it is also a useful tool to keep the seller engaged after they’ve received the majority of the purchase price.
Despite the usefulness of earn-outs, in many instances, inclusion of an earn-out can lead to conflict between the buyer and seller following the closing. Before you accept an earn-out for your M&A sale, be sure to keep these important considerations in mind.
What Should I Consider Before Accepting an Earn-Out?
A seller should first consider the financial impact that will result from the failure to achieve an earn-out. While the potential upside may be a much higher total purchase price, an earn-out is never a sure thing. There is risk involved in an earn-out for even the most stable business.
If a seller is comfortable with the risk involved with an earn-out, the next (and usually most complex) consideration is the earn-out metrics or milestones. Many earn-outs are based on financial metrics such as sales, net income, or EBITDA. While these are good measurements of success for many businesses, there’s no one-size-fits-all solution, so an earn-out may be appropriately measured against milestones such as product launches, product development, customer headcount, or other metrics.
The earn-out measurement must align with the buyer’s plans for the business during the earn-out period. For example, if a buyer plans to move the seller’s product manufacturing in-house, the parties should consider how that move will impact costs, which in turn may influence the earn-out.
To account for these potential changes to operations and strategy following the closing, some sellers (but not all) are able to negotiate buyer covenants during the earn-out period. These covenants place some sort of restrictions around how the buyer operates the business during the earn-out period. Common examples are a requirement to maintain staffing levels and to keep pricing and/or expenses in line with historical norms. The specific covenants must also be carefully considered, and a seller should spend time trying to anticipate the most likely ways that the earn-out could be frustrated. On the other hand, most buyers will be resistant to any restrictions on their ability to operate the business as they see fit following the closing.
Finally, a seller should be realistic regarding the earn-out targets. It can be tempting to believe that the company will achieve new levels of success right away based off synergies between the seller and buyer, but it is vital for a seller to insist that earn-out targets are achievable. Utilize your knowledge of the business in order to establish milestones that you feel will more than likely be achieved within the agreed-upon timeframe.
Ultimately, these earn-outs provide a business owner with a big opportunity – an easier sale of their business, and potentially receiving even more than expected from the sale if all goes well. Owners must make sure not to get distracted by the possibility of a higher payout, however. Nothing is guaranteed until the earn-out is fulfilled, so evaluating these metrics and weighing the risk involved is key to getting a successful earnout.
Earn-outs also require some very careful drafting to give yourself the best chance of success, including accounting for the many contingencies that could eliminate your payout. With a quality agreement, you can ensure that a prospective buyer will continue good faith efforts to meet your milestones, and fulfill the earn-out. If you’re selling your business and need quality legal counsel to ensure you get a successful deal, give us a call at (720) 306-1001 or email firstname.lastname@example.org.