Considerations When Earn Outs Are on the Table – from Jordan Zweigoron

Although earn outs are extremely common and often beneficial to Sellers and Buyers alike, many sellers are hesitant to consider an earn out as an element of a Purchase Agreement.

Earn outs are future payments based on the attainment of predefined metrics. Earn outs are commonly based on revenue goals (one, two, or even three years down the road), but can also be based on profitability or other metrics.

Before that knee jerk reaction sets in (“I will only consider an all-cash offer”), consider that earn outs can have many benefits to Sellers.

Sellers seek the best possible earnings multiple at the time of sale, while buyers seek to minimize this multiple.  Earn outs can help to bridge this gap to bring buyers and sellers into alignment on deal terms.  Hypothetically, let’s say the Seller is seeking a 3x earnings multiple, and the buyer is only willing to pay 2.5x. An earn out equivalent to a .5x multiple can bridge this divide, and make the deal happen.

Sellers and buyers are always aligned with respect to earn out goals –both want the earn out metric to be achieved. For this reason, it’s often possible for a Seller to negotiate an ongoing consulting arrangement. In this case, the Seller is paid as a consultant, strictly to ensure that the earn out metric is achieved. This creates an ongoing consulting revenue opportunity for the Seller, with sufficient motivation to make even more money when the earn out is achieved.

When structuring earn outs, I like to “soften the edges” of the earn out metrics. For example, if an earn out stipulates “$50,000 in 12 months if revenues of $2M are achieved,” consider also negotiating for “$45,000 in 12 months if revenues of $1.6M are achieved.” This approach removes the “all or none” proposition often contemplated in earn outs. If you achieve 80% of the earn out metric, you still receive a payout.

Similarly, using the above example, what happens if revenues in 12 months exceed the earn out target?  Sellers can often negotiate an over-achievement metric, eg “$75,000 in 12 months if revenues exceed $2.5M.”

When earn outs are well structured and negotiated, they can be extremely useful tools to bring Buyers and Sellers into deal alignment, and to focus mutual objectives on the right metrics during the transition period.

Jordan Zweigoron is a Senior Advisor with Sunbelt Business Brokers. He can be reached at (408) 436-1900, x105, or at [email protected]. Or connect with Jordan on LinkedIn.