What is an Earn Out in a Business Sale?
Reaching a mutually acceptable purchase price can be difficult. The seller and the potential buyer may disagree on the value of the business. An Earn Out can resolve such a disagreement. It enables the parties to hold different opinions on the business value, but agree on the terms of the transaction.
An acquisition with an Earn Out establishes a base purchase price that is guaranteed. The Earn Out is a contractual term that increases the base purchase price if the post-closing performance of the business reaches agreed upon thresholds. The Earn Out may be a fixed amount or determined with a formula. It may be calculated based on bottom line earnings, such as net profits or operating income, or it may simply be based on gross revenue.
For example, a fixed Earn Out may state that if a specific milestone is reached within two years after closing, the seller is entitled to an additional $500,000. An Earn Out formula may state that the seller is entitled to a percentage of gross revenue above a certain target each year, for five years following closing. A formula based Earn Out often has a cap, or maximum amount that it can generate for the seller.
With an Earn Out being tied to the business’ future performance, the buyer and seller should have clear expectations. A well drafted purchase agreement stating the terms of the Earn Out is crucial. Consideration of the impact on other transaction terms is also important. For example, if the seller is able to negotiate continued employment in a key role with the business after selling it, the seller can have a direct impact on whether the Earn Out is achieved. If the seller makes a clean break with the business at closing, the Earn Out is completely dependent upon the buyer’s performance post-closing, and the seller is essentially a spectator waiting to learn the results.
An Earn Out transfers risk from the buyer to the seller. A seller with high performance expectations may accept this risk, especially in a situation where the buyer is less informed, or less optimistic, about the seller’s future projections. A well-negotiated Earn Out will compensate the seller for this risk, with a commensurate reward if the high expectations are met. Additionally, the Earn Out can be structured as an incentive for key employees to remain with the business after closing.
There are drawbacks to an Earn Out. Tracking the performance requires independent accounting of the acquired business for a period of time after closing. An overly complicated Earn Out can be difficult to administer and may result in a disputed outcome. Also, the retained key employees of the business may seek to prioritize short term performance over long term goals to maximize the Earn Out.
The pros and cons of an Earn Out should be carefully considered by both the buyer and seller before agreeing to it. An Earn Out is a valuable tool that can help make deals that would otherwise fall through, but it is not right for every situation.
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