An Earn Out Payment is additional future compensation paid to the owner(s) of a business after it is sold. The terms and conditions that yield an earn out payment are contained in an Earn Out Agreement which is part of the Agreement of Sale. Typically, this payment is dependent on specific terms and conditions being met by the business as it operates in the years following the sale.
In recent years, Earn Out Payments have become very common in Mergers & Acquisitions. Yet many advisors, business sellers, and buyers find the inclusion of an Earn Out Payment Agreement in a deal’s structure problematic. But this does not have to be the case if the seller and buyer align the terms in the Earn Out Payment Agreement with their common post-closing objectives.
Why are Earn Out Payments Used?
One reason Earn Out Payments exist is due to a difference or gap between what a buyer is willing to pay the owner of a business and its asking price. An Earn Out Payment can bridge the gap between respective valuations in order to close the sale.
Earn Out Agreements also are used when a buyer disagrees with the seller’s projected profitability and expected growth. In this case the company must meet certain profitability expectations in order for the buyer to pay the seller additional compensation.
In both cases, it’s important to understand that an Earn Out Payment is not guaranteed to be paid to the business owner unless such a guarantee is specified in the Earn Out Agreement and the agreement’s terms are met.
Who Should Consider an Earn Out Agreement?
Earn Out Agreements have become increasingly common in recent years and they are most popular in times of economic and political uncertainty. And while any type of business sale may consider an Earn Out Agreement, they tend to be most popular among private equity investors who may not have the expertise to keep the business running on its own after the purchase. In such cases an Earn Out Agreement may be used to entice the former business owner to remain involved in the business following the sale.
Regardless of the type of business, Earn Out Agreements should be considered only when the company will be operated and managed the same in future years as it is at the time of sale. This is the better way to project future performance. But if future plans involve dramatic shifts in operation, an Earn Out Agreement may not make sense, especially for the seller.
What is an Earn Out Payment Formula?
Earn Out Payments may be linked to almost anything to which a willing seller and buyer can agree. Examples of measurements typically found in Earn Out Payment formulas include: Gross Revenue, Gross Profit Margin, EBITDA, Adjusted EBITDA, EBIT, Gross Revenue per Full Time Employee, Employee Retention Rates, Gross Revenue Growth Rates, and more.
Typically an Earn Out takes place over a three to five year period following acquisition. Generally, sellers should be cautioned to limit the time frame of the payout since an Earn Out Agreement could defer anywhere from 10 to 50 percent of the purchase price.
Limitations and Cautions When Considering an Earn Out Agreement
When considering the terms of an Earn Out Agreement a cautious seller should limit their exposure only to terms over which they have control. Otherwise the fate of the seller’s Earn Out Payment could fall into the hands of the buyer or other parties after the closing.
For example, an Earn Out Payment tied to profitability of the business after the sale would be unwise unless the seller remained in management control. Even if the seller retains full management control after the business is sold, this type of Earn Out Payment measurement may not be ideal. The buyer may worry the seller could understate expenses or overstate revenue to ensure the future payout.
Conversely a seller may worry the company could be purposefully mismanaged in an effort to miss the performance targets required for additional compensation to be paid to the seller. Nevertheless, it’s always best practice to tie the Earn Out Payment formula to a measurement or metric which will be within the seller’s control after the sale of the business.
Who Should Negotiate the Earn Out Agreement Terms When Selling a Business
To avoid potential conflicts after the closing, the buyer and seller should make certain their respective representatives have a thorough understanding of the business’s operations and its cash flow. While it’s not uncommon for the business broker or M&A Intermediary to negotiate on behalf of their respective clients, these advisors generally do not have a deep understanding of the seller’s business.
Likewise, the seller’s attorneys know much about transaction law, but typically don’t understand the selling business’s finances. Accordingly, it’s best to consider assigning the negotiation of the terms and conditions of the Earn Out Payment to the business owner and his or her Chief Financial Officer.
While Earn Outs certainly can offer peace of mind and fair value to both the buyer and the seller, they require extra time to negotiate, draft, and implement, and they could result in a lost sale or extra costs for the buyer or seller, including litigation and auditing.
That’s why it’s always best practice to enlist the services of an attorney with extensive experience creating well-reasoned and legally binding Earn Out Agreements which make sense for both the buyer and the seller.