How to Structure an Earn-out
When there's a valuation difference between what a buyer thinks a business is worth and what the seller expects to profit, an earn-out can bridge that gap. Here's how to make a deal that's good for both parties.
What's the value of your business? That depends on whom you ask. Ask potential buyers, especially when they're being cautious in tough economic times, and it might not meet your expectations.
Negotiating a sale of a privately-held business is never a breeze – and it's much less so in a down market in which there is little competition among buyers to drive up the multiple. When a seller's expectations aren't being met by potential buyers, including an earn-out provision in the acquisition contract can help narrow the price-expectation divide.
A common feature of many acquisitions, an earn-out stipulates that the original owners of a business are paid for the sale of their company, following which they are contractually obligated to stay with the company through a transition period, and they are provided with the incentive to have a demonstrable effect on the company's financial performance going forward. Achieving or exceeding a certain level of performance – criteria are typically set over a period of several years – means the original owners will earn a much larger profit from the sale. For buyers, an earn-out can offer the owner protection against overpaying for a company that doesn't end up thriving or growing in the way its original owners expected. It can also smooth the period of ownership transition.
Call it an incentive; call it delayed gratification; call it a compromise. Brian Mutert, founder and CEO of San Francisco-based investment bank Stratagem, which specializes in mergers and acquisitions, says earn-outs can benefit both buyers and sellers.
"It's a way for the buyer to put some skin in the game for the seller after the deal closes, and to provide some financial incentive for them to work hard in terms of the company's business after they close the deal," he says. "In a situation where the seller might believe there is a great opportunity for future growth potential, they can take some added benefit in the transaction."
Dig Deeper: What's Your Business Worth in a Buyers' Market?
Structuring an Earn-out: Setting Realistic Expectations
When there is a gap between an owner and a potential acquirer in the perceived value of a business, it is usually caused by the expected future growth of the company. That's only natural. But as a small business owner, it's necessary to step back and ask yourself: If your expectations are higher than those of your buyer, why is that?
After all, it's commonly known that roughly three-quarters of all mergers and acquisitions fall short of the expectations that are stated when the deal is announced. And about half of all deals result in a loss of value for the buyer's shareholders. So, analyze exactly what you're optimistic about – and how much of your purchase price you're willing to risk on being successful in the future.
Being equipped with solid expectations for your businesses success over the next five years can prepare you well for negotiating an earn-out.
Consider next what portion of your asking price you'd be willing to risk – and work for in the future.
"An earn-out is a contingent payout, which essentially involves shifting some of the purchase price to be paid in the future on the realization of future earnings or some other benchmarks of success," says George Geis, an associate dean of the Executive MBA Program at UCLA's Anderson School of Management. "So the owner needs to be wiling to delay some of the price, and be aware they might never get it."
Because most earn-out clauses are tied to the company's performance (measured in sales, earnings, or some other benchmark) over a three-to-five-year period, that's the timeline you should be thinking about your company's health within before embarking on negotiations. If your company had a track-record of performing at or exceeding forecasts in the past, this fact should give you added negotiating power.
Knowing expectations is vital is because the range of earn-out terms that could be offered is vast. A buyer might agree to pay 90 percent of the total purchase price you desire upfront with the remaining 10 percent paid in stock or cash after a year of earn-out time. Alternately, the buyer might split the sale price 50/50 over five years during which time the owner must agree to stay with the company and optimize its performance.
When Disney acquired Club Penguin in 2007, for example, it paid $350 million upfront, with $350 million more promised through a series of earn-outs. For high-tech and service businesses with high-growth potential, a typical deal might include an upfront payment from an acquirer of between 60 and 80 percent, with the balance paid over time possibly as an earn-out tied to performance.
Geis estimates that, in the post-dot-com-boom era, the owners of private companies regularly have been taking between 40 and 45 percent of the total pay-out through an earn-out agreement, according to surveys. If you are embarking on a sale, you will want to make sure you know their future involvement is worthwhile – and is the best way to spend time for the money offered.
Dig Deeper: What Happens After You Sell a Business
Structuring an Earn-out: Keeping it Simple
For entrepreneurs looking for a quick sale of their business, the simple
st earn-out is none at all. There are significant risks involved in any acquisition that involves future conditions – especially when the old owner is expected to come on board to work for someone else and live by their rules.
"A CEO must recognize they will not be in control of their own destiny in any part the same way they were," Mutert says. "They will have new bosses and will have to march to a new set of rules than they had to when it was their own company."
Many earn-outs depend on an extremely complicated matrix of variables and goals. This should be avoided if possible. Earn-outs are most effective as an incentive for the seller when the size of the payout is determined based upon one or two simple variables. A buyer who constructed a complicated set of goals covering earnings, customer retention, and myriad other circumstances should be challenged. These conditions might not be fully under your control should you accept the earn-out. And too many variables – especially when some are out of your hands – can make achieving your earn-out impossible, Geis says.
"What you don't want to happen to make it so they control you and that you don't make your earn-out," Geis advises sellers. "That can be that they control some marketing expenses or some other element that would change the game for you and take any control of the situation out of your hands within a year or so out."
In order to avoid spending years of your life working on a possibly unattainable goal, you'll want to enter acquisition negotiations armed with a legal counsel, as well as financial advisors, specializing in mergers and acquisitions. Instruct them to fight for a simple deal with an earn-out based on an easy-to-quantify metric, such as higher corporate revenue or an expanded client base.
