What is an Earn-Out?

Financing is an important aspect of business acquisitions and there are several forms a buyer can take advantage of their acquisition. The most obvious ways have already been worked out for you in this knowledge base. One particular form of this we will elaborate on in this article: the Earn-Out.

What is an earn-out?

A buyer can build up the financing of the purchase price with different layers of financing. Think cash, bank loan(s) and a vendor loan, for example. One way to distinguish between these financing layers is the timing of payment: up front at the time of the transaction (undoubtedly the seller's preference) or in the post-transaction period, whether or not based on the results achieved (the buyer's preference). As part of the purchase price financing, the earn-out falls into the second category. However, it can also be an additional amount on top of the agreed purchase price.

Thus, the earn-out is a form of financing. But what exactly is it? In essence, an earn-out is a legal arrangement, a contractually agreed obligation, between a seller and a buyer that describes a fee paid by the buyer to the seller if certain conditions are realized in the future. In practice, this is often about achieving financial targets (expressed as EBIT, EBITDA or sales), but it does not have to be. Certain production volume could also be possible, or staff retention.

The important thing to remember is that this is a payment that is uncertain and only paid out upon the achievement of agreed-upon goals. It may be clear, that these goals must be detailed.

Why use an earn-out?

In most cases, a seller will want to receive the highest possible return for his or her business. And on the other side of the table is the buyer, who obviously prefers to pay as little as possible for the acquisition because he or she sees more risk, for example. There can be a gap between the seller's asking price and the buyer's offer even in the final stages of a negotiation. An earn-out is a way to compensate for this difference in value perception: the buyer actually says that he or she will pay more (perhaps even the asking price of the sale) under the condition that the company to be taken over will indeed achieve the results that the seller has portrayed in his or her forecasts in the sales memorandum.

The earn-out is then the variable part of the purchase price that is paid on top of the fixed part of the purchase price, and which serves to mitigate the risks of the buying party.

The benefits of an earn-out

  • The buyer pays for what he or she actually received (a company with result X). So his risk is substantially lower.
  • For the seller, the earn-out can be a way to receive a higher purchase price.
  • Stalled negotiations can be restarted with a good and clear earn-out construction.
  • An earn-out is only paid after certain performance has been achieved. In practice, this part of the financing can often be met from the cash flow of the acquired company (which thus pays for itself).
  • Usually the acquisition will be easier to finance: banks and investors also see the lower risk and the amount to be financed directly is significantly lower.

Disadvantages of an earn-out

  • The main disadvantage for the seller is that the receipt of this part of the acquisition price is not certain. And that he or she depends on the buyer to what extent the agreed milestones are met and the earn-out is actually paid. The seller's influence is usually minimal after the acquisition.
  • Earn-outs often lead to disputes. Especially when they are based on interpretation-sensitive concepts such as "profit" (profit is an opinion!).
  • Arrangements often become (too) complex, with which implementation and compliance become so.

Tips and points of interest in earn-outs

Should you wish to get started on working out an earn-out after reading this article, keep the following points in mind at a minimum:

  • The performance to be recorded must be absolutely clear, as must the definitions to be used. The terms profit, EBIT, EBITDA are too interpretation-sensitive and easy to manipulate. Rather, use earn-out based on revenue targets, visitor numbers, order numbers, order size any staff retention or certain dealerships. Always avoid terms that are multi-interpretable!
  • Make sure earn-out terms are clear with deadlines and dates.
  • Agree how to measure: what accounting principles will be followed (GAAP). And if you do agree on an earn-out based on EBITDA or gross profit: make clear which column balances are used to determine the amounts.
  • How is the earn-out paid by the buyer to the seller and at what time?
  • And what happens if the targets are (just) not met? A buyer then may not want to pay anything. Whereas for a seller it may be expedient to agree on a "sliding scale," where 90% of the earn-out is paid when 90% of the targets are met.

Conclusion

Think carefully about whether you really want to work with an earn-out. There are many snags (especially for the seller). And if there are multiple offers, we ourselves would drop the offer with the (largest) earn-out component first. Earn-outs are often a source of much hassle, but sometimes there is no other way to reach a transaction. In that case, make sure the construction is crystal clear to all involved, with as few interpretation and manipulation options as possible. After all, better one bird in the hand, than ten in the air!