October 22, 2020
Earn-outs exist as mechanisms for reducing the risk of overpaying when buyers acquire intangible assets known as goodwill. They also serve to help sellers realize the full potential of the future performance of their business after they relinquish control.
What is an earn-out?
When a business is sold, an earn-out can be applied to any portion of the purchase price that is not paid in cash on the day of closing. I should probably back up a step: when buyers purchase a business, they often break the purchase price up into segments, each performing a function to help them get the deal done. A good example would be owner financing (you might also hear this called a note, seller note, owner carry, etc). An earn-out is a similar tool that buyers sometimes employ to mitigate downside performance risk when the purchase price exceeds the value of the company’s tangible assets. Earn-outs are applied to the “goodwill” portion of sale proceeds.
When an earn-out is part of the deal structure, it is typically used to put conditions on part of the purchase price. These “conditions” characteristically have a time component, along with hurdles for other metrics that the buyer desires to manage in their favor. Such metrics might be: keeping certain customer accounts through a transition period, meeting future revenue and/or margin goals, completing major work in progress, etc. An earn-out allows the buyer to “pay-up” for future performance once that performance has been accomplished. It ensures the buyer is at least partially hedged should the business underperform forecast results after they have assumed control. As transaction advisors, we see both the upside and downside of earn-outs and believe that when properly structured and used situationally, they can play a vital role in helping buyers and sellers reach agreement. However, earn-outs are not for every seller or every situation as we will discuss below.
When is an earn-out the right tool for a deal?
When selling your business, if you believe it is set to out-perform forecast metrics and you negotiate proper controls to keep scorekeeping fair, then an earn-out is a great tool to help you maximize the total value of your sale. It can also help defer taxes, convince lenders and investors that you believe in the business’s trajectory, and help you participate in the upside you prepared the company to achieve - even though it takes place under your successor’s stewardship.
This can get complicated though, as no longer having control over the business means the buyer can - and will - begin to make changes (with the best of intentions) that may disrupt the future plans that gave you confidence in the earn-out provisions in the first place. Therefore, the downside of earn-outs is they are often not realized (or are only partially realized) – which is why we counsel our clients not to “count” proceeds tied to an earn-out. We like to view any sale proceeds captured from an earn-out as lagniappe.
Earn-outs are negotiated contracts.
As with any negotiated contract, it is up to the seller and the buyer to determine and agree upon the “rules”: payment triggers, dates, accounting thresholds, and other important metrics. Earn-out proceeds can be capped or open-ended. One thing we always insist upon is that a reputable, third-party, accounting firm either keep or certify the books. It will be hard for self-serving accounting to take place if this check is in place. Obviously, you will need the right to audit and challenge the accounting prior to “mutual acceptance” of the final tally. As crazy as it sounds, we sadly see most earn-out agreements lacking these basic checks and balances. Therefore, it pays to have some assistance negotiating earn-out nuances.
When an acquisition involves industry consolidation or is a bolt-on or roll-up (which merges or consolidates companies, at least in some fashion), the upside case for an earn-out may be strong as the acquiring business would be expected to bring efficiencies, purchasing power, cross-selling opportunities, and other synergistic attributes. The contract details regarding how those items are applied towards the earn-out equations are extremely critical.
Be aware. We occasionally see seasoned buyers floating the idea of an earn-out during the early “tire-kicking” phase just to gauge a seller’s body language and confidence in their projections.
In conclusion, an earn-out can be a powerful mechanism to bridge expectations and manage risk - helping both sides get to a deal they believe works in their best interests. Buyers often need protection against sliding performance during the integration, training, and learning-curve period of their tenure as a new owner. Sellers often feel like they cannot let go of their company until they have milked every drop of the business’s potential. During M&A transactions, earn-outs are a mechanism both parties can employ to achieve their goals.
About GaP Business Advisors
Gilbert & Pardue Business Advisors (GaP) is a Houston-based business advisory firm serving lower middle market and middle market business owners from coast to coast through representation for Mergers & Acquisitions (M&A) and through business value-growth services such as Fractional CFO, Advisory Board, Executive Coaching, and Consulting.
Matt Gilbert and Bret Pardue established GaP to provide owners of businesses generally enjoying annual revenue of $5-$75 million with the quality of M&A representation and value-enhancement services previously only available to upper middle and large businesses. GaP brings highly-experienced executives, sophisticated financial and marketing products, proven-effective processes, and fully-integrated expertise to every engagement. No other M&A firm serving the lower middle and middle market provides the quality of representation and transactional expertise that we do.