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Do earn-outs work as a deal structure when selling a business?

Kenneth H. Marks
Profile Picture of Kenneth H. Marks Mr. Marks is the founder and Managing Partner of High Rock Partners, Inc. He is the lead author of Middle Market M&A: Handbook of Investment Banking Business Consulting and Handbook of Financing Growth: Strategies, Capital Structureand M&A Transactions, 2nd Edition both published by John Wiley Sons, and he authored the publication Strategic Planning for Emerging Growth Companies: A Guide for Management.  Full Bio
Q:I am in the process of selling my business and the buyer has proposed an earnout. From your experience, do earn-outs work and what should I look out for?
A: I can reference multiple transactions, even for larger mid-market businesses and say that when you have deals with contingent consideration or staged payout, the amount of cash at closing tends to be a deal breaker if the parties can’t get to that right number. I would couple that with overall valuation and what I call a value gap. Not having a good way to bridge that value gap can be a big deal breaker.

Earn-outs can bridge this valuation gap if they are structured properly and have the right dynamic within the overall business pre and post close. Where an earnout works is when you have the operator or the owners of the business that are going to remain with the business post close for a period of time and have operational control. The business will remain an operating entity and the core elements of the business are under the control of the existing owner.

Also the term of the earn-out needs to be structure properly where performance measures are very clear and unambiguous. For example, earn-outs should have a very easy to track metric like a revenue or a gross profit. It’s harder as you get to net income or EBITDA because of accounting issues and allocations can skew that number. The longer the earn-out period, the harder it is to measure, so a shorter earn-out period has a higher probability of achieving the objective of this payout mechanism.

One of the problems we see in earn-outs that cause them to fail is when they are structured as binary events, meaning you hit this number, you get the payout. I have seen earn-outs being more effective when you can make it somewhat linear or fall within a range; then it’s not all or nothing. We find that when it’s scaled, it works.

Our firm completed a transaction with a company that had a recurring revenue stream from an existing customer base. The buyer was willing to pay an earn-out as long as that customer base hit a certain level and continued to grow. We were able to structure an earn-out that was very achievable on the low end and made it scale upwards, so it was a win-win for both the buyer and the seller. I’d say another important component for earn-outs is that there is a true economic gain for both the buyer and the seller. So the incentive is there for the buyer wanting to pay the earnout, as well as the seller wanting to achieve the threseholds.

There are two other points that I think that are really important. One is that the definitive purhcase sale agreement should actually illustrate and define the calculation for the earnout. Even to the level of identifying what general larger accounts are included from what aren’t. A problem that may arise is the people that are going to do the calculations in the future may or may not be involved in the transaction. They may not be involved in the deal at all or the company a year or two later. I think having a really clean roadmap helps eliminate the arguments and makes the calculation much less ambiguous. I think also crafting and documenting the intent of the earnout calculation to go with those numbers is equally important. Now attorneys don’t like to put that stuff in legal documents but from a layman’s perspective or operating perspective, it really is helpful. I’m a big advocate of putting those two things in as a schedule in the definitive documents.

The last overarching component on the earnout is, if the seller does not trust the buyer or the culture and the people within the buyer, an earnout will not work. If the culture of doing what’s right and trust is not inspired as part of the chemistry of the buyer, the earnouts don’t work. So I know that’s a soft issue but it’s pretty important.

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