There are a number of ways that the sale of a business can be structured. 100% all cash deals are rare. In most cases, deals are created where a combination of cash, financing, stock, and/or earn-outs are used. The key to any structure is ensuring that it protects your financial legacy and is set up so that you are able to close an optimal deal with a premium buyer. In this piece we will examine typical earn-outs and their features.
According to Investopedia, the definition of an earn-out is:
“A contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals.”
The official Generational Equity definition is similar:
“The portion of the purchase price that is contingent on future performance. It is payable to the sellers only when certain predefined levels of sales or income are achieved.”
According to George Geis, an associate dean of the Executive MBA Program at UCLA's Anderson School of Management, in an Inc.com article from a few years ago:
"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. So the owner needs to be willing to delay some of the price, and be aware they might never get it."
I have highlighted similar key points in the passages above to illustrate one of the critical features common to all earn-outs: They are tied to the future performance of the acquired company POST-acquisition. As such, there is tremendous upside (and downside) to an earn-out structure.
Christine Lagorio-Chafkin, a senior writer with Inc., expands on these definitions and makes an excellent point regarding the risk of an earn-out to a seller, as well as the potential benefits:
“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.”
So two things that we encourage all of our clients to consider as we work with them to create their five-year pro forma that will be used by buyers to determine the value of the company:
Both of these are equally important and need to be carefully considered by any business owner before approaching a buyer. Keep in mind that quite often an earn-out of 2-3 years time will generate MORE for you than simply selling the company and walking away from it. As we have discussed before, the one common trait that all buyers have is an aversion to risk. An earn-out is a great way to bridge the gap between what you believe the company can do going forward and the concern a buyer might have about it not coming to fruition without your involvement.
The most important first step is to work with your M&A advisor to create a five-year projection of your company’s recast financials that are defendable, are achievable, and – most importantly – do not raise concerns about the veracity of all your documentation. For example, if your company's historic compound annual growth rate of revenue and earnings is 5%, forecasting this to improve throughout the next five years to 30% is going to do more harm than good.
And, if you do find a buyer that is willing to talk to you about acquiring your business, a good portion, most likely 30-50% or more, will be “contingent.” So if your projected growth instead of hitting 30% is half or less, so too will your future payouts. You never want to fall into that trap, working really hard for an additional three years post-close and not reaching your ultimate valuation target. It can really lead to disappointment and bitter feelings. And don’t expect the new owner of the company to feel sorry for you and revise the structure of the deal. That is not likely to happen!
Which leads us to the second point: You are going to have to continue working hard to make your projections a reality. Far too many sellers ASSUME that simply because you are no longer shouldering 100% of the risk of running the business, and that you now have a new boss to help make key decisions, that the level of time committed to the earn-out will be less than was required to run it when you were the sole owner. That is rarely the case. If you are working with a skilled M&A advisor, he or she will work hard to stipulate what your new role will look like and what you will be directly responsible for during the earn-out period.
Make sure that any earn-out you negotiate is clear regarding what targets will need to be reached going forward AND what your role will be in helping to achieve those goals. Typically earn-outs combine some form of revenue and earnings growth. Ensure that your agreement with the buyer is clear regarding what those milestones will be AND what you will be doing to achieve them.
For example, if your goal is revenue growth of 10% during the next three years and net profit improvement from 10% to 15% during the same timeframe, then make sure that you have the ability, in your new role, to make both happen. Far too often we encounter business owners who have sold their businesses without an M&A advisor, using an earn-out structure only to realize far too late that the goals are not clearly outlined nor do they have the authority in their new role to make them happen. That is why working with an M&A advisor is so critical when selling your company. If they are experienced in structuring deals, they will work to ensure that any transaction will protect you and your financial legacy.
A final thought: One earn-out structure that we recommend you avoid if at all possible is creating a contingent program that sells your business to either your employees or family members. The problems with an earn-out with either of these groups are legion. The most critical being that usually neither of these groups brings any capital to the table. Too often they will need to obtain a loan (with a high interest rate) or, worse yet, have you finance the transaction AND saddle you with an earn-out to boot. Then, overnight, no longer do you have employees but you also have partners – does that change the dynamics of the business!
This situation is even worse if you are selling to family members. Imagine Christmas dinner in the not too distant future where your offspring or siblings are several months behind in paying you your contingent payments. The tension as you share the eggnog could be cut with a knife. You want to avoid that at all costs.
To summarize: An earn-out is a legitimate deal structure quite often used by dealmakers to bridge the perceived gap between the value a seller sees in the future earnings of a business and the risk a buyer envisions with them. Caution must be used when creating forecasts that you present to buyers AND you need to be sure that you will have the motivation to work hard, or harder, with a new boss than ever before.
And this leads us to one final thought as well: Get to know your buyer as you go through due diligence. Ensure that you can work well with him/her because going forward, you will now have a new boss for the first time in years. The importance of this cannot be over stressed. If you are not comfortable with the style, substance, and nature of your buyer, then working closely during a 2- to 3-year earn-out may not be optimal.
If you would like to learn more about all forms of deal structuring, including earn-outs, I invite you to attend a Generational Equity M&A executive conference near you. An investment of a few hours of your time will yield tremendous growth in your understanding of the exit planning/M&A process and will protect you from making any bad decisions when you are negotiating with a buyer (assuming that you don’t have the services of an experienced M&A advisor).
Carl Doerksen is the Director of Corporate Development at Generational Equity.
© 2014 Generational Equity, LLC All Rights Reserved
The information we learn from customers helps us personalize and continually improve your experience at gencm.com. Here are the types of information we gather.
Information You Give Us: We receive and store any information you enter on our Web site or give us in any other way. We do not sell or rent your personal information to others without your consent. We use the information we collect only for the purposes sending promotional information, enhancing the operation of our site, serving advertisements, for statistical purposes and to administer our systems. We DO NOT use third parties to provide customer service, to serve site content, to serve the advertisements you see on our site, to conduct surveys, to help administer promotional emails, or to administer drawings or contests, but reserve the right to do so in the future without advance notice. Our computer system protects personal information using advanced firewall technology.
Information from Other Sources: For reasons such as improving personalization of our service, we might receive information about you from other sources and add it to our account information.
Generational Capital Markets LLC may license the use of its intellectual property including but not limited to its name, likeness, and logo for the use of affiliated offices. Such affiliated offices may not be owned, controlled, managed, supervised or staffed by employees, officers, or agents of Generational Capital Markets, L.L.C. Affiliated offices may be independently owned and operated. For more information about a particular office, please contact Generational Capital Markets LLC at is office in Dallas, Texas.
This page may contain other proprietary notices and copyright information, the terms of which must be observed and followed.
INFORMATION ON THIS WEB SITE IS PROVIDED "AS IS" WITHOUT WARRANTY OF ANY KIND, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, THE IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE, OR NON-INFRINGEMENT. SOME JURISDICTIONS DO NOT ALLOW THE EXCLUSION OF IMPLIED WARRANTIES, SO THE ABOVE EXCLUSION MAY NOT APPLY TO YOU.
Information on this web site may contain technical inaccuracies or typographical errors. Information may be changed or updated without notice. Generational Capital Markets may also make improvements and/or changes in the products and/or the programs described in this information at any time without notice.
Generational Capital Markets does not want to receive confidential or proprietary information from you through our web site. Please note that any information or material sent to Generational Capital Markets will be deemed NOT to be confidential. By sending Generational Capital Markets any information or material, you grant Generational Capital Markets an unrestricted, irrevocable license to use, reproduce, display, perform, modify, transmit and distribute those materials or information, and you also agree that Generational Capital Markets is free to use any ideas, concepts, know-how or techniques that you send us for any purpose.
Information Generational Capital Markets publishes on the World Wide Web may contain references or cross references to other products, programs and services that are not announced or available in your country. Such references do not imply that Generational Capital Markets intends to announce such products, programs or services in your country. Consult a Generational Capital Markets representative for information regarding the products, programs and services which may be available to you.
Generational Capital Markets makes no representations whatsoever about any other web site which you may access through this one. When you access a non-Generational Capital Markets web site, please understand that it is independent from Generational Capital Markets, and that Generational Capital Markets has no control over the content on that web site. In addition, a link to a non-Generational Capital Markets web site does not mean that Generational Capital Markets endorses or accepts any responsibility for the content, or the use, of such web site. It is up to you to take precautions to ensure that whatever you select for your use is free of such items as viruses, worms, trojan horses and other items of a destructive nature.
IN NO EVENT WILL Generational Capital Markets BE LIABLE TO ANY PARTY OR ANY DIRECT, INDIRECT, SPECIAL OR OTHER CONSEQUENTIAL DAMAGES FOR ANY USE OF THIS WEBSITE, OR ON ANY OTHER HYPERLINKED WEBSITE, INCLUDING, WITHOUT LIMITATION, ANY LOST PROFITS, BUSINESS INTERRUPTION, LOSS OF PROGRAMS OR OTHER DATA ON YOUR INFORMATION HANDLING SYSTEM OR OTHERWISE, EVEN IF WE ARE EXPRESSLY ADVISED OF THE POSSIBILITY OF SUCH DAMAGES.
Furthermore, all information contained within this website is the property of Generational Capital Markets.
Honored to win Investment Banking Firm of the Year 3 years running.
Over 50 awards and counting.
Sign up to receive regular email updates, industry-leading insights and details on complimentary M&A executive conferences in your area from our award-winning team
Success, you have been added to our list.