Selling a business is not always easy if the buyer and seller do not agree on the market value of the company. Sometimes the buyer will be hesitant over the company’s potential to generate future revenue. Either that or the buyer may not have the cash available to purchase the company for the seller’s asking price. If the seller doesn’t want to lower their asking price because they feel their company has a high value, then one solution is for the seller to accept an "earn-out payment" from the buyer. This can make it fair for both the buyer and seller to go through with the deal.
What is an Earn-out?
When a company is in the process of being sold, the sales contract may contain a provision known as an "earn-out". This provision entitles the seller to receive a specific percentage of the company’s gross earnings after ownership is transferred over to the buyer. It all depends on how valuable each party believes the company to be. But if the company does not generate sales growth after a certain number of years, then the seller does not get any earn-out.
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An earn-out is basically a contingency payment. There is no fixed percentage set for the earn-out rate. It is whatever the buyer and seller agree on it to be. That is the beauty part of having an earn-out provision in a sales contract. The buyer and seller can set the terms of the earn-out. It might take a little while for them to come to an agreement on it, but it usually works out nicely for both parties in the end.
How is an Earn-out Calculated?
Let’s take a look at a couple of examples so you can get a better idea of how earn-outs are calculated.
1) As the seller, suppose you believe your company is worth $10 million. When you go to sell your business, you find an interested buyer who thinks the company is worth $5 million. That is the price they are willing to pay, and they won’t go any higher. In order to strike a deal, you agree to receive $5 million at the closing and another $5 million as an earn-out payment. You make a deal with the buyer that if the business generates at least $20 million in sales over the next 3 years, they pay you the $5 million. But if the sales only reach $10 million in 3 years, they pay you $2.5 million more instead. The performance of the business will determine how much of the earn-out is actually paid to the seller if any at all.
2) Suppose you own a small business that has experienced at least 10% sales growth over the last 3 years. You currently estimate the value of your business to be $1 million and you expect that value to increase to $1.1 million within 3 years. However, the buyer who is interested in purchasing your business will only pay $1 million. So, you work out a deal where the buyer pays $1 million upfront and then a 10% earn-out over a 3-year period if the company has generated $1.1 million in sales within that time.
Benefits for Sellers
The biggest benefit that a seller has from an earn-out payment is the potential to make more money off the sale of their business after it is already sold. Since it is a contingency payment, the business must continue profiting after the sale for the earn-out to be paid to the seller. In other words, if you are the seller and you’ve put years of hard work into your company, you may want to continue profiting from it even after you’ve sold it. An earn-out makes this possible.
In addition, an earn-out makes it easier for you to strike a deal with a buyer. If the buyer cannot afford your asking price or they don’t trust your predictions about the company’s growth potential, an earn-out is the next best option. You are not owner-financing your company to the buyer because they are still paying you a hefty upfront payment. Then you will receive the remaining amount of the company’s value once the profits come in. But if they don’t come in, you’ll still get to keep the upfront payment that you received.
Benefits for Buyers
The buyer will benefit from an earn-out deal because they won’t be required to pay the seller’s entire asking price upfront. More importantly, the buyer will have an easier time trusting the seller’s future predictions of business growth if they are willing to make an earn-out agreement. When there is this kind of trust generated, it makes the transaction more pleasant for the buyer. If it turns out the seller (you) was telling the truth about the company’s value, the buyer will end up with a profitable company that will continue to make them money for years to come.
Drawbacks and Pitfalls for Sellers
As beneficial as earn-out agreements may seem, they can be quite contentious for both buyers and sellers. Earn-out agreements are quite complicated to draft. There are so many underlying terms and incentives which may exist for the buyer if you don’t read everything carefully. The earn-out agreement must clearly state all the milestones for your payments and the incentives that each party receives.
For this reason, it is highly recommended that you seek the services of an attorney before you enter into an earn-out agreement. An attorney will know how to structure the agreement properly so that it benefits you to the fullest. Otherwise, you might leave something beneficial out of the agreement that you won’t realize until it is already signed. The buyer will probably want to let their attorney review the earn-out agreement too. That way, they can be assured that their interests are protected as well.
Aside from the extra expense of hiring attorneys, you also must worry about the buyer actually running your business effectively. You could potentially end up in a situation where the buyer doesn’t do a good job of managing the company and as a result, it doesn’t make any profits. This means that you won’t receive any earn-out payments. The only money you’ll have is the upfront payment you received at the day of the closing.
Tax Implications for Sellers
Earn-outs have some positive tax implications for sellers. Since you will not be receiving the entire one-lump sum of your asking price, you only need to pay taxes on the money that you do receive from the buyer. If the earn-out payments are ever made to you at some point in the future, then you will be obligated to pay taxes on those payments as they come in. Until then, you are not required to pay taxes on any earn-outs that you have not received yet.
Structuring an Earn-out Agreement
Let’s examine the basic structural elements of a properly organized earn-out agreement. These are the considerations you need to make:
Determine if you should use an earn-out agreement.
Sellers do not always benefit from earn-out agreements. You must consider whether you’ll benefit from an earn-out agreement after the buyer takes over ownership. Do not assume the buyer will just run your business the exact same way you did. They might have plans to merge the business with another business they own.
If that is the case, it could have a negative impact on the future performance of the company and the potential you have for receiving the earn-out payments that you were expecting. Therefore, the earn-out agreement must have a stipulation where the buyer agrees to keep the business running the same way. This will increase the chances of the earn-out payments being made.
Remember that both parties are supposed to benefit from an earn-out agreement. If the buyer insists on having earn-out terms which only benefit them, do not agree to them just for the sake of making a sale. You must benefit too or else it is not worth it.
What amount will the earn-out be?
The earn-out amount is generally a percentage of the upfront payment. The standard earn-out is between 20% and 30% over a certain number of years. Like if the sales price was $1 million and there was a 30% earn-out, then you would receive an additional $300,000 in total payments throughout those years.
If the buyer is taking on a higher risk, it means that your company’s potential to generate future profits is in doubt. When this happens, the buyer might pay you a smaller upfront payment but then agree to a larger earn-out if the company ends up profiting as you promised. This makes it initially less risky for them to go through with the deal under these conditions.
What is the term length of the earn-out agreement?
The term length of a standard earn-out agreement is anywhere from one year all the way up to five years. The buyer and seller will decide on which term length is appropriate. You won’t typically see a length longer than five years because the company is expected to profit within the next few years after the sale.
In fact, it is always better for the seller when the term length is shorter rather than longer. If you can arrange a one-year term length for the earn-out agreement, you will be able to earn your contingency payments faster. The buyer will only agree to this if they believe the company can generate profits that quickly.
How is the earn-out measured?
Buyers are commonly in favor of measuring the earn-out by basing it on the EBITDA. This is an acronym that stands for "earnings before interest, taxes, depreciation, and amortization.” Sellers do not prefer this because they no longer have power over their company after the deal is made. This means they can no longer manage the EBITDA.
For better security as a seller, you should use gross margins or revenue milestones as the basis for the earn-outs. You’ll want a few simple variables to be used when calculating the earn-out. If it becomes some long mathematical formula, it will be more difficult to understand the earn-out and you’ll likely end up at a disadvantage.
What are the conditions of the earn-out?
This is a very important element of an earn-out agreement. You must establish specific conditions for how the business will be run after the buyer takes over. For instance, you could set a condition which states that the head managers and supervisors of the organization must keep their jobs. If certain departments still require your leadership, you can set a condition to retain managerial control over these departments after the closing is done. This will assure you that the organization is still being run effectively so that profits can be made and earn-outs can be paid.