Structuring an earn-out

An earn-out is a pricing structure when selling a business, where the seller must ‘earn’ part of the purchase price, based on how well the business performs after the sale. You’ll ‘earn’ a percentage of the agreed price over a specified time frame.

The terms and conditions of an earn-out can also depend on who manages the business following the sale. If the new buyer takes over on day one, you as the seller will want to ensure the business is well run so it hits sales targets.

The key factor for you as the business owner and seller is to make sure you’re protecting your financial legacy with an optimal deal. That’s why it’s important to obtain legal advice as soon as you can.

Putting some skin in the game

Most earn-out deals require you to stay on during the transition period. This is a good thing because it means you know exactly what’s happening and you’re motivated to live up to the expectations of the earn-out. In order for it to go smoothly, there are two key factors to keep in mind right from the beginning:

• Be honest about the true potential growth of your company. There’s no point in overstating things and then falling short. Make sure the terms of the deal involve realistic expectations of growth and profit
• Plan on working just as hard, if not harder, after the acquisition as you’ll have an incentive to do so.

Structuring the earn-out deal

When you’re negotiating the deal, make sure you consider:

• The portion of the sale price you’d be willing to risk and to work for during the transition period
• The length of the transition period, how long are you willing to stay on and the sales targets
• The terms of the deal. There’s any range of terms that you and the seller might consider. For example, the buyer might agree to pay 80% of the total price upfront, with the remaining 20% paid in stock or cash after the transition period. Or you could split the sale price 50/50 over a 5-year period, which is the timeframe you have to improve the business’s performance.

Keep it simple

If at all possible, try to avoid a complicated combination of goals and objectives; that kind of deal is more open to interpretation down the track and could lead to misunderstandings when it’s time to close. Earn-outs are most effective as an incentive for the seller when the size of the payout is determined based upon one or two simple variables.

Strengthening the agreement

Still keeping realistic targets in mind, living up to the terms of an earn-out deal is easier if you make sure it includes a few key elements:

• Make sure you can retain the staff you need. If you have employees who are integral to your business success, you’ll need them during the transition period
• Avoid ‘earn-out burn-out’ by making the transition period as short as possible. You can always renew and re-negotiate but can’t go backwards
• Retain control where it makes sense. The agreement should state explicitly who is overseeing the management of the business, especially those involved in achieving the targets in the earn-out deal
• Make sure there are good incentives in place. The earn-out percentage should be high enough to keep you from losing interest
• Take care if the buyers are employees or family. Often they won’t have enough capital and could be required to finance the transaction and the earn-out deal.

Summary

The key factor to keep in mind is that in most earn-out cases, it’s possible you’ll be required to stay on for a stated time frame, and that during that time, be in the best place possible to make sure the business achieves all its goals.

It’s also important to be realistic about what growth targets you can expect your business to hit. It’s one thing to talk your potential up if you’re selling and walking away; it’s quite another to have the responsibility of living up to that potential as part of the deal.

Make sure you consult with professionals when considering an earn-out deal. They will make sure the agreement is structured properly with as much benefit to you as possible.