What is an Earn Out - Ultimate Guide

Determining the true value of a business can be a complex undertaking. Both buyers and sellers aim to secure the best deal, yet they often find themselves on opposite ends of the valuation spectrum. Enter the concept of “earn-outs”. Whether you're an aspiring buyer or a business owner gearing up for a sale, join us as we delve into the following:

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What is an Earn-Out in Business Acquisitions?

An "earn-out" is a financing arrangement prevalent in mergers and acquisitions (M&A). It allows the buyer and seller to bridge any valuation discrepancies by making part of the purchase price contingent on the future performance of the acquired business.

How Does an Earn-Out Work?

Here's a simplified breakdown of how an earn-out might work:

Initial Agreement: A buyer and a seller agree on a base purchase price for a business, say $10 million. They also agree that there will be an additional $5 million payment (the earn-out) if the business achieves a certain revenue target in the next year.

Performance Monitoring: After the acquisition, the performance of the business is tracked for the agreed-upon earn-out period (e.g., one year).

Payment Contingent on Target: If, at the end of the year, the business hits or exceeds the revenue target, the buyer pays the additional $5 million. If the target isn't met, the buyer might pay a reduced amount or nothing at all, depending on the terms negotiated.

Key Considerations in Earn-Outs:

Details Matter: The specifics of the earn-out – what metrics are used, the duration of the measurement period, how payments are calculated if targets are only partially met – are all crucial and should be clearly detailed in the purchase agreement.

Risks: There are potential pitfalls. The business could underperform due to external factors or because of decisions made by the new owner. There's also the risk of disputes over whether the targets have been met, especially if the metrics or terms aren't clearly defined.

Alignment of Interests: Ideally, an earn-out aligns the interests of the buyer and the seller. The seller has an incentive to ensure the business is on solid footing and is well-positioned for future success. The buyer is reassured that some of the purchase price is tied to future performance, reducing the risk of overpaying for the business.

Duration: Earn-outs can last for varying lengths of time, but they typically range from one to five years.

Management Role: Often, the seller (or the original management team) remains involved in the business during the earn-out period to ensure continuity and to help achieve the specified targets.

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What is an Earn-Out Payment?

An "earn-out payment" is the contingent payment made by the buyer based on the acquired business's performance, as stipulated in the earn-out agreement. The metrics often used relate to financial outcomes like revenue or profitability.

Here's how an earn-out payment might typically work:

Setting the Terms: During M&A negotiations, the buyer and seller might agree on an initial sale price for a business (e.g., $10 million). Additionally, they agree that if the business achieves a specified revenue target within a year post-acquisition, there will be an earn-out payment of an additional $2 million.

Tracking Performance: After the acquisition, the business's performance is monitored for the agreed-upon period.

Making the Payment: If the business achieves the set revenue target at the end of the year, the buyer makes the earn-out payment of $2 million to the seller. If the business falls short of the target, the payment might be reduced proportionally, or it might not be made at all, depending on the specific terms set out in the earn-out agreement.

Key points about earn-out payments:

Purpose: Earn-out payments are a way to bridge valuation gaps between a buyer and seller. If the seller is optimistic about the business's future performance and the buyer is more cautious, an earn-out agreement can help both parties come to terms. The seller has the potential to achieve a higher price if the business performs well, while the buyer doesn't overpay upfront for potential that may not materialize.

Clarity is Essential: For earn-out payments to be executed smoothly, the metrics and terms of the earn-out must be clearly defined in the acquisition agreement. This minimizes the risk of disputes.

Potential Conflicts: Earn-outs can lead to conflicts if the business doesn't perform as expected. The seller may feel the buyer didn't manage the business effectively, while the buyer may feel the seller overestimated the business's potential. Clear terms and conditions can help mitigate these disputes.

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Earn-Out Structures in M&A

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Earn-out structures are a way to manage the risk and bridge valuation differences in mergers and acquisitions (M&A) by tying a portion of the purchase price to the future financial performance of the business being acquired. They are particularly beneficial when there's significant uncertainty regarding the future growth and performance of the target company.

The specific terms and conditions of earn-outs can vary widely based on the nature of the business, the concerns of the parties involved, and the forecasted performance metrics. Here's an overview of some common earn-out structures:

Revenue-Based Earn-Outs:

• The payment is linked to the target company's future revenues.
• This is straightforward and easy to measure, but it doesn't necessarily reflect profitability.

Profitability-Based Earn-Outs:

• The earn-out is tied to profitability metrics, such as EBITDA (earnings before interest, taxes, depreciation, and amortization).
• This ensures that the acquired company is not just generating revenue but is also profitable.

Milestone-Based Earn-Outs:

• Payments are tied to non-financial metrics or achievements, like securing a key regulatory approval, launching a new product, or retaining specific customers.
• This is often used in sectors like pharmaceuticals, where regulatory milestones can be critical.

Tiered or Scaled Earn-Outs:

• Multiple performance tiers are defined. If the target business reaches a certain level, the earn-out payment is 'X', but if it exceeds and reaches a higher level, the earn-out is 'Y'.
• This structure can motivate sellers to not only achieve but exceed targets.

Cap and Floor Structures:

• A maximum (cap) and minimum (floor) earn-out payment are defined.
• This structure ensures that the seller receives at least a minimum amount if certain basic conditions are met, while also placing a limit on the buyer's total payment obligation.

Time-Based Earn-Outs:

• Payments are spaced out over set intervals, such as annually or quarterly, over the earn-out period.
• This can provide ongoing incentives for sellers (especially if they remain involved in the business) and spreads out payment obligations for the buyer.

Ratchet Mechanisms:

• These allow for incremental changes in the earn-out payment based on performance.
• For instance, for every 1% increase in profits above a threshold, there might be a corresponding 0.5% increase in the earn-out payment.

Equity-based Earn-Outs:

• Instead of cash, the earn-out might be in the form of equity or stock in the acquiring company.
• This aligns the interests of the seller with the long-term success of the larger merged entity.

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Pros and Cons of a Seller Earn Out for the Seller

Pros for the Seller:

Higher Potential Price: An earn-out can help bridge the valuation gap between the seller's and buyer's perspectives. The seller may receive a higher total purchase price if the business performs well post-acquisition, as compared to accepting a lower upfront payment.

Facilitates Deal Closure: If there's disagreement on the future potential of the business, an earn-out can be a middle ground that allows both parties to move forward with the transaction.

Alignment with Future Performance: If the seller is confident in the future success of the business, an earn-out provides an opportunity to benefit from that future growth or success.

Reduced Risk for Buyer: By making a portion of the sale price contingent on future performance, the seller can make the deal more attractive to the buyer, potentially facilitating a quicker sale.

Ongoing Involvement: Many earn-out agreements come with a role for the seller in the continuing operations of the business, ensuring their expertise and relationships are retained.

Cons for the Seller:

Delayed Payment: A portion of the sale price is deferred, meaning the seller might not receive the full payment for the business for several years.

Potential for Lower Payment: If the business doesn't meet the specified targets or milestones, the seller might not receive the full earn-out amount.

Dependency on Buyer's Management: Post-acquisition, the seller might not have full control over business operations. Poor decisions or changes made by the buyer could impact the business's performance, and consequently, the earn-out.

Complexity and Potential for Disputes: Earn-outs introduce added complexity to M&A agreements. Ambiguities or disagreements about performance metrics can lead to disputes.

Lack of Clean Break: Sellers might prefer a clean exit from the business. With an earn-out, they remain financially and sometimes operationally tied to the business for an extended period.

Tax Implications: Depending on the jurisdiction and how the earn-out is structured, there might be different tax implications for earn-out payments as opposed to receiving the entire sales price upfront.

Risk of Non-Payment: If the buying entity goes bankrupt or faces severe financial challenges, the seller might not receive the earn-out payment.

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Pros and Cons of a Seller Earn Out for the Buyer

Pros for the Buyer:

Risk Mitigation: The buyer pays the full purchase price only if the business meets certain performance metrics. This minimizes the risk of overpaying for a business that doesn't live up to its expected potential.

Facilitates Deal Completion: If there's a valuation gap between the buyer and seller, an earn-out can be an effective tool to bridge the difference and move the deal forward.

Retention of Key Personnel: Earn-outs often involve the continued involvement of the seller or the original management team. Their expertise and relationships can be essential for the business's ongoing success.

Improved Cash Flow Management: By deferring a portion of the purchase price, the buyer can better manage their cash flow and may not need to secure as much financing upfront.

Alignment of Interests: The seller becomes financially motivated to ensure the business performs well post-acquisition, which can align the interests of both parties toward the company's success.

Cons for the Buyer:

Potential for Higher Price: If the business performs exceptionally well, the buyer might end up paying a higher total purchase price than what they might have negotiated without an earn-out.

Complexity: Earn-outs add complexity to the transaction, both in terms of the initial agreement and in monitoring and enforcing the terms post-acquisition.

Potential for Disputes: Ambiguities or disagreements about performance metrics, calculations, or other earn-out terms can lead to disputes, which can be time-consuming and costly.

Operational Limitations: Some earn-out agreements may place restrictions on how the buyer can operate the acquired business, limiting certain strategic changes or investments that might negatively impact the earn-out metrics.

Extended Involvement with the Seller: Depending on the terms, the buyer may need to continue working closely with the seller or original management team, which can be challenging if there are differences in vision or strategy.

Financial Uncertainty: While earn-outs can help with initial cash flow, they introduce future financial obligations that depend on the performance of the acquired business.

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Are Earn Outs Allowed with an SBA Loan?

Earn-outs, wherein the seller remains with the business for a predetermined period and receives extra payments contingent on the company's financial achievements, are not allowed when financing with an SBA loan. Such arrangements, although designed to ensure a smoother transition under the new management, can potentially cause conflicts that jeopardize the business's stability.

Reference: Getting an SBA Loan to Buy a Business

However, those looking to secure an SBA loan have alternative options to bridge the financing gap. One such alternative is using a seller note to finance a portion of the business's purchase price. Recent changes in SBA regulations have made it possible for lenders to finance up to 90% of a business acquisition, and in some instances where the acquisition is viewed as a business expansion, this can even extend to 100%. By coupling this with a 5% seller note, borrowers can effectively acquire a business with a minimal down payment of only 5%. Check this article to find out more about Seller Notes and SBA Loans for Buying a Business.

Conclusion

In mergers and acquisitions, earn-outs bridge valuation differences and reduce risks for both buyers and sellers. While they offer potential benefits, such as allowing sellers to maximize their business's value and helping buyers mitigate overpayment risks, earn-outs also come with challenges. Clear terms and effective post-acquisition management are crucial for success. Whether a novice or expert in M&A, understanding earn-outs is vital for crafting beneficial deals.

We hope you found this blog post insightful! If you need help with your business plan or financial projections, ProjectionHub Services is here to assist. Let us know how we can be of service to you!