When it comes to selling a business that you’ve worked hard to build and develop, maximising returns should be on top of your list of priorities. Here we’ll outline earn-outs, their pros and cons, and how they can help achieve the best possible sale price.
Just what is an earn-out?
An earn-out is a contractual agreement as part of a business sale where the seller can obtain additional compensation should the business meet outlined financial goals, usually earnings. It may be in the form of cash or company shares.
Typically, an earn-out is determined by considering the profits for one or two years after completion. However, it is completely reasonable to tie the earn-out to revenue or any other monetary indicator relevant to the deal and to how the business was valued.
What’s the catch?
Earn-outs are beneficial for both the buyer and the seller. An earn-out can mitigate doubt in the buyer’s mind around the business’s profitability, ensuring the seller can realise the full potential of the sale. The buyer can trust that the price is directly based on the business’s performance; it allows the opportunity to defer a portion of the purchase price and incentivises the seller to support the buyer beyond the transition.
There can, however, be a few drawbacks with an earn-out. The seller retains a stake in the business and remains actively involved instead of a clean break on completion. It’s also typical for the seller to have certain restrictions outlined in the contract for the earn-out period.
The negotiation
Establishing the guidelines for calculating the profit amount (or relevant financial metric) is crucial for earn-outs. Employing the accounting techniques and principles utilised in generating the target company’s accounts for the period concluding before completion serves as the typical starting point.
However, discussion about additional adjustments for debts or for other outstanding items that the parties will be aware of, including relocation costs because of the transaction, and redundancy costs, will commonly arise.
Any advantages the target company has received due to the buyer’s purchase may also be excluded by the buyer. Two examples of this are the reduced workforce and increased purchasing power of a larger group. This is typically a contentious issue for both the buyer and the seller.
Seller protection
Even if the seller continues to be involved in the target business after completion, there is a chance that the buyer’s actions could artificially lower the earn-out. This could include shifting business to other group companies and levying disproportionately high intra-group management fees.
To protect the seller, the contract can include clauses restricting the buyer from taking actions that might have these outcomes. This can be addressed by including explicit restraints, the violation of which would result in legal action for contract breach. It can also be dealt with by excluding such items from the profit calculation.
Security
In a deferred payment, the seller needs assurance that the buyer can pay, especially if the buyer does not have substantial assets. For security from a seller’s perspective, it can request they are granted a registered security interest over shares or assets of the company or that the earn-out is guaranteed – either by a bank or parent company.
Key takeaway
Even though an earn-out can be the subject of complex negotiations between the seller and the buyer, it has the potential to have significant benefits for both parties because it enables the seller to maximise the sale proceeds of the business or company and the buyer to continue using the seller’s expertise and knowledge during the crucial post-closing handover period to maximise the value of its investment.