An earn-out is increasingly being used in business acquisitions. An earn-out means that part of the purchase price is paid only if the business achieves certain results after the acquisition.
It sounds logical and fair: the seller gets a higher return if the business continues to perform well. In practice, however, earn-outs regularly lead to misunderstandings.
Below, we highlight four common misconceptions about earn-outs, and what steps you can take to avoid them.
'An earn-out means that the buyer and seller do not agree on the value' 2.
Earn-outs are often seen as a solution when there is a valuation difference, but this is by no means always the case. In the current market, where the bank is more cautious in terms of financing and uncertainty about future performance is higher than in the past, an earn-out offers a practical way to link (part of) the purchase price to actual results achieved.
In such situations, there is no fundamental disagreement about the quality of the business, but rather a constructive solution to financing constraints and external risks.
'If the business is doing well, I'll get my earn-out anyway' 2.
It depends entirely on the terms agreed upon. These can be based on a variety of metrics, such as revenue, gross margin or EBITDA. Strong revenue growth does not automatically mean earn-out, especially if costs rise or gross margins decline.
'We'll sort out the details later' 3.
Earn-outs touch multiple disciplines: legal, financial, and operational. Both buyers and sellers sometimes underestimate the impact of making a global deal without elaborate provisions.
Consider ambiguity about the measurement period, exceptions, whether or not to correct figures or how to deal with extraordinary circumstances. It is precisely these details that determine whether an earn-out goes smoothly or turns into discussion.
'An earn-out is just hassle, so it's better to avoid it' 4.
Earn-outs do indeed require clear agreements, good monitoring and transparent communication. But that does not necessarily make them undesirable. In many cases, an earn-out is actually a workable instrument to make the transaction acceptable to both buyer and seller without making concessions to the purchase price. If properly designed with clear conditions and objective measurement methods, an earn-out can contribute to a successful transaction.
An earn-out can be a valuable part of an acquisition structure, provided it is carefully designed. Misunderstandings often arise from vague agreements or unspoken expectations. Therefore, ensure clear, written agreements on conditions, responsibilities, reporting and monitoring.
In doing so, pay attention to the legal, financial and operational aspects. In addition, get timely guidance from an adviser with experience in acquisitions and earn-outs. This will increase your chances of finding a workable solution for both parties and prevent discussions afterwards.
