"The objective is to quantify uncertainty."

It is no revelation that buyers want to acquire companies based on "today's" earnings and "today's" book value.  On the other hand, sellers want to sell their company based on "tomorrow's" expected earnings.

 

Many potential acquirers are accustomed to offering sellers, for example, five times EBITDA by structuring the deal with 30% equity, 50% borrowed from the lender, and 20% notes or consulting/non-compete agreements with the seller. However, this "conventional" structure does not always work for the buyers or sellers.

Many successful buyers go beyond the conventional norm in bidding for a company.  For those acquirers which are public companies, the use of their publicly traded stock is an obvious advantage.  For those acquirers which are private companies, their remaining trump card to "pay up" for a desirable acquisition is the EARN-OUT.

According to James W. Bradley, co-author of Acquisition and Corporate Development:  

The earn-out is a contingent purchase which allows some deals to go through that would otherwise be impossible.  Sometimes the seller's price is such that the transaction can only be justified by the buyer at levels of future earnings considerably above what the buyer can expect with any degree of certainty.  Here an earn-out may allow the deal to be consummated.  Under certain circumstances earn-outs may qualify as non-taxable transactions.

Earn-outs can be complicated to structure and monitor, but they are most desirable under the various scenarios:

• The buyer has limited equity.
• The seller has very rich price expectations.
• There is a significant price gap between buyer and seller.
• Acquisition of service companies (relationship businesses).
• Acquisition of companies introducing new products.
• The owner is willing to stay on two to five years.

An example for an earn-out formula used by a very successful public company is as follows:
a)   Pay the owners one to two times book value at closing.
b)   Then pay owners an additional percentage of Net After Tax (N.A.T.) over a five year period.
c)   The payment based on the multiple of book value (a) is finally deducted out from the earn-out payment (b)
d)   Sample of earn-out:
                                    Net After Tax
      Year                       Multiple
      1                 x          15%
      2                 x          15%
      3                 x          20%
      4                 x          25%
      5                 x          25%  

Considerations

The acquiring company usually places a maximum earn-out or "cap" on the deal.  The acquirer will want to be sure that the income from the earn-out comes from continuing operations and not extraordinary or non-recurring events.  One of the reasons the earn-out works for both parties is that the acquirer agrees to invest money in the acquiree - computer systems, sales and marketing resources, etc. -  to help accelerate the N.A.T.  While a definitive dollar amount is not pre-determined, the acquirer wants to make every effort to please the owners, because the success of the next acquisition will be voiced by the owners of the last acquisition.

The above variation is just one example of numerous alternatives.  In fact, the most common benchmark for earn-outs is a percentage of Earnings Before Interest and Taxes (EBIT) with covenants regarding which party makes major decisions, what changes will be allowed, and if necessary, how to implement arbitration.

If a seller is willing to accept an earn-out arrangement, a more aggressive pricing strategy can usually be formulated.  The objective of the earn-out is to quantify uncertainty.  Earn-outs are used to bridge gaps between an asking price and a bid price as well as to motivate the seller during the period of transition.  And, one should recognize that the seller must be satisfied with the initial "down payment" as compensation for the company.  Any earn-out payments, if and when they come, are "gravy."

Conclusion

There are some companies who are very vulnerable because they have but a few customers or the owner is still involved in many facets of the business.  These are often necessary situations in which acquirers must protect themselves with an earn-out arrangement.  Furthermore, there has been a tendency to use earn-outs as a method of protecting the purchaser who has not done an adequate due diligence investigation. 

Earn-outs should be limited to offering solutions to legitimate differences or when a seller's major concern is to spread out income in taxable transactions with resulting tax benefits.  The success of earn-outs is only limited by the principals' creativity and willingness to compromise.