In an earn-out, the original owners are paid an agreed upon price for the business. Then, they are obligated to stay with the company through a transition period and are paid an incentive based on the performance of the company. Essentially, the seller must "earn" part of the purchase price based on the performance of the business after the sale.
If the company achieves or exceeds the performance targets the prior owners net more from the sale of their company. If the company does not achieve these goals, the buyer has protection against overpaying.
Earn-outs should not be confused with seller financing. Seller financing is a loan provided by the seller of a business to the purchaser which is paid back over time. It is used when the parties agree on a price, but the buyer cannot secure enough cash to buy the business outright. We will leave this topic for another day.
Clearly there are risks with an earn-out, especially considering that the old owner is expected to work for the new owner.
Here are a few things to think about:
Metric: Most earn-outs are tied to the company's performance, such as sales, earnings, or some other measure over a three-to-five-year period.
Seller's usually prefer to keep the measure unambiguous and as close to the top line of the income statement as possible, such as revenue. Not surprisingly, buyers generally prefer a bottom line measure such as net earnings. It is best to keep it simple and easy to quantify.
Financial Resources: The seller will want to be sure s/he has the resources at his disposal to influence the performance goal. For instance, if the goal is new customer acquisition, you want to be sure the marketing budget stays intact.
Key Players: Similar to keeping the necessary financial resources in place, it is also important to retain key employees that are critical to realizing the goal.
Control: Make sure you have management oversight over any departments that execute on your goals. Again, if your goal is new customer acquisition, then you better have oversight of the sales department.
Length of Contract: Keep it as short as possible. You can always renew or renegotiate. But things change, and you want to be sure you can actually exit the business in a timely manner (after all, that is what this is all about, right?)
Processes: Be sure to have clear processes in place to both measure performance as well as pay out the incentive. It is always good to include an example in the earn-out agreement. Define a process to resolve any disputes that might arise.
If you are thinking about incorporating an earn-out in the sale of your business, keep it simple and understandable. And, be sure to engage experienced legal and financial advisors to help you work through the nuances.
If you would like to discuss how we can help you structure an earn-out agreement, please give us a call. We would be happy to help.
Until next month, Point Your Business Where it Needs to Go!
Best Wishes,
Kelly
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