When selling a business, how do you bridge the gap between the price owners want and the price buyers are willing to pay? Sellers are usually optimistic that the business revenues and earnings will grow and want to be rewarded for future cash flows. Buyers generally have to rely on historical results and are not inclined to rely on or pay for forecasted growth. One way to bridge the gap is through an earn-out arrangement.

What is an Earn-Out?

Earn-out agreements generally require the original owners and sometimes key management team members to stay with the company for a transition period, usually several years. If the company meets or exceeds the stated financial performance criteria, the selling owners can get additional payouts or profit on the deal. For the buyer, it offers some protection against overpaying for a company that doesn't grow the way the seller had expected.

Be Aware of the Risks for Buyer and Seller

Earn-out and contingent purchase payments can include significant risks for both the seller and the buyer, and sometimes result in disputes or even litigation if both parties' interests are not aligned, so simple variables and goals are best. Consider: 

• Targets may include revenue, customer retention or net earnings.
• Sellers need to be sure they control the levers or activities needed to reach those goals.
• Buyers need to be sure that the earn-out targets are strategic to their goals for the company.

For example, an incentive to hit a revenue mark might be accomplished by the selling owner at the expense of gross margin or profitability; while an incentive to hit a net-profit target, could result in decisions that reduce future growth or profitability.

Secure Commitment

In addition, the earn-out period should be as short as possible and the dollars large enough to keep the seller interested and committed to the company's future success. It can be an advantage to have targets and payments throughout the earn-out period that reward results along the way.

Want to Learn More?

If you are considering selling or buying a business, an earn-out could be an option to bridge the gap for both parties. Contact your Eide Bailly representative to learn how we can assist you with transaction planning, as well as the tax and accounting implications.