When selling a company, determining the (earn-out) purchase price is obviously a prominent part of the negotiations. The seller has confidence in the future growth of the business, while the buyer is particularly concerned with the risks.
To bridge that gap, a so-called earn-out is regularly chosen. A clever solution, but also often a source of discussion.
What is an earn-out?
An earn-out is a component of the purchase price that is made contingent on future performance. In addition to a fixed purchase price, buyer and seller agree that an additional payment will follow later if certain goals are achieved. For example, consider an additional payment if revenue or EBITDA reaches a certain level in the coming year. In this way, the seller shares in future growth, while the buyer runs less risk in advance.
Earn-outs can be a solution to break a deadlock in negotiations, for example, when parties differ on the purchase price or on identified risks. The earn-out is a particularly useful tool for acquisitions of businesses active in sectors where growth is difficult to predict and where the sellers remain actively involved in the business for some time after the sale. After all, the earn-out provides a strong incentive for sellers to remain motivated to further grow the business even after the sale.
And then discussion anyway?
Precisely because the payment of the earn-out depends on future results, discussions regularly arise about the achievement of the set goals, the amount of the earn-out, the moment and the method of payment. Many earn-out arrangements often turn out afterwards to be less clear than parties think. Although the included arrangement seemed very clear beforehand, certain parts turn out to be open to multiple interpretations.
Suppose, for example, that the buyer is going to invest a lot in the business after the takeover, thereby reducing profits or that costs of the business after the takeover are allocated differently by the buyer. Does that then lead to the seller not being entitled to an earn-out payment? Such questions are fodder for lawyers, but as a business owner you obviously don't want them.
Seller, don't get rich!
An earn-out is common and can work well in practice to achieve a win-win situation between buyer and seller. At the same time, it is important that the seller does not get rich too soon when accepting an earn-out. No matter how rosy the seller envisions the company to be sold, the amount of the earn-out may still end up at zero for whatever reason.
The earn-out is best regarded as a "bonus" on top of the fixed purchase price. Viewed by itself, the fixed purchase price should be sufficient. The earn-out is an additional side benefit: fine if it is paid out, but not a disaster if the payment is unexpectedly omitted. Only then should the earn-out be acceptable from the seller's perspective.
Clear agreements are crucial
If seller and buyer choose to work with an earn-out, making clear agreements in that context becomes crucial. Both parties benefit from clear agreements and objective measuring points that reflect the parties' intentions as closely as possible.
Concrete tips:
- Keep the wording simple and clear
- Add calculation examples
An earn-out can be a clever bridge between buyer and seller, but without clear agreements that bridge quickly turns into a source of misery. An open door, but therefore - especially as a seller - get good advice before signing the earn-out.
Are you considering buying or sell a business and does an earn-out play a role? Then get timely advice, so that the agreements not only make a deal possible, but also prevent future discussions.
