Simply put, earn outs are when a seller receives additional compensation from the buyer only if pre-determined bench marks are hit in the future by the new owner.  The intent of the buyer is not to hand over all the cash up front at the date of purchase, but for an installment type sale based upon the future successes of the company.The risks, or actually reality more often than not, is that the new owner does not hit the bench marks and the seller never receives additional monies above the original cash paid.   Earn outs are becoming more popular as financing options have dwindled and creative incentives for both parties are being created.The theory here is that both parties involved will benefit from the deal.  The seller, who usually is up selling the great business potential, now has to put their money where their mouth is.  The seller usually gets a higher price with this deal since it’s considered an add-on to the upfront cash paid.  Often times the seller has produced financial projections of great growth and profits to validate the price and the buyer is asking them to be part of that projection.  The seller wins if the company hits the pre-determined numbers and they also can defer the income proceeds over a few different tax years. The buyer, who is valuing the business off of history not projections, can justify a higher price and can afford to pay more for the company if the projections come true.  They are not taking the all the risks themselves and now have included the seller as an interested party in the deal.  The earn out allows for the buyer to purchase a company a little more than they can afford, have the payments deferred over a period of time, limit the risk so they are not paying for something that “might be” and they keep the seller’s interest in the success of the company.    It is often used when small companies in high-growth, high-tech or service industries are sold. Generally speaking the buyer pays 60–80% of the purchase price up front (cash or bank financing) with the remaining 20–40% structured as an earn-out.  It is often paid out over a set time (1-5 years) as the acquired company achieves certain levels of sales or profitability.Tensions can arise in an earn out arrangement since the seller wants to be involved to make sure the targets are hit.   This can cause a conflict between the buyer and seller when they disagree on the best direction to take the company in order to hit the future targets.The length of time it takes to receive an earn-out is a very important part of the sale negotiation.  Obviously if the seller receives a payout over a 5 year period they will want to see that the buyer can manage the business.  Both parties will have to agree on the way the business will go after it’s goals, what the minimum working capital needs are and that the business won’t be pillaged by the new owner.  Inevitably there will be a challenges and tension.The typical area of tension is around the financial management of the business.   The buyer will want the majority of the control since they just bought a majority of the company.  The seller will need to allow the buyer the control but also need to have policies in place so they can jump in quickly if things start going poorly.  Compromise is the only solution here and the seller needs to be aware that without controlling interest, the targets will be difficult to hit.As an attorney who helped me with my business sale once said, “don’t be surprised how badly a qualified buyer can screw up a perfectly good company”.  Unfortunately, over the years of advising others, I have to say he was right.  It is absolutely amazing to me how buyers come into a new company and start making changes.   An earn-out can work for both sides providing each person is prepared to be practical and they have a clear understanding of terms and conditions from the start.  Unfortunately earn outs rarely do work.  Just like a marriage, the honeymoon and first year of marriage is fun, new and everyone is excited about the future.   Unfortunately running a successful business is not easy and battles come up later about the definitions used, the accounting policies and methods of measurements and the amount of management charges which may be imposed by the new business owners.I don’t want to tell you not to use an earn out clause when negotiated the price and terms to the sale of your business.  Just go in with your eyes open and know that it can work but it has some significant pit falls.  Like a marriage, when it works all is good, but if it goes bad then expect an ugly battle. 

Be smart, be crystal clear and document everything.  Once the deal is cut, you no longer have control, the money or the company.  It works well on some deals but go in with your eyes wide open.

This entry was posted on Wednesday, December 23rd, 2009 at 1:04 pm and is filed under Sell Your Business, Selling a Small Business, Professional Advice, Exit Stories, Emotional Selling, Exit and Answers, Buy a Business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.