Love them or loathe them, earn-outs are a fact of life when selling a service business. It is rare to see an M&A transaction in which an earn-out is not required, so better to set the expectation now than to confront it at sale time unprepared.
For those unfamiliar with the term, an earn-out is fundamentally a time and performance commitment from the vendor to the buyer. It is a defined period of time post-sale that the vendor commits to remaining with the business and driving performance, ostensibly so that the purchaser doesn’t lose the value in their investment that might otherwise disappear if the business were heavily reliant on the owner. It is a risk-mitigation strategy for the purchaser, ensuring that the business is left in the best possible state when the vendor departs.
The term is so named as the arrangement is for the vendor to “earn out” a proportion of the sale price, rather than expecting the buyer to take all of the risk and front 100% of the consideration at Completion of the deal. As long as it is constructed appropriately, an earn-out can provide upside for both buyer and seller.
Unfortunately…
If not constructed properly from the outset, earn-outs are open to abuse from both parties to a transaction. Many will have heard stories of business owners who failed to achieve their earn-out payments due to the purchaser lumping costs onto their P&L during the period or making material changes to the business, or tales of vendors stripping costs out to artificially inflate earnings, leaving the buyer with a shadow of the business they thought they had purchased. No happy endings here…
Earn-outs are more often than not subject to performance of the acquired business at an EBIT level during the defined period, generally with expectations of growth or at the very least maintenance of current earnings levels. Sometimes they are measured against revenue or gross income results, or subject to transition milestones such as suitable replacement of the principal, retention of key staff/clients or attainment of a major contract. Any way you cut it, an earn-out is an agreement between the two parties that the business will be fully transitioned within an appropriate timeframe.
So what does a good earn-out arrangement look like?
First and foremost, the best structure is based on fairness to both parties. It recognises the inherent value in the acquired business and incentivises the vendor to not only stay, but drive the business forward. I don’t like deals in which the earn-out payment is only triggered when a higher level of performance is achieved, but ones where the payment varies based on performance is fair for both parties. I also don’t like seeing deals where the buyer is basically seeking the deal to self-fund, in which case the vendor is no better off going through the process of selling compared with just keeping the business for the same period of time and closing the doors.
Secondly, an earn-out should not be for an extended period. Buyers are restricted from making material changes during an earn-out, and vendors who have been self-employed for a decade often find it a difficult transition to having a reporting relationship again. It is therefore in both parties’ interests to make the earn-out period as short as necessary to achieve the desired result.
And finally, the parameters governing the earn-out are defined in detail in the contract. This will avoid any disputes (that may/will arise) around calculation of earnings and payment triggers. The best structures I have seen measure performance against budgeted expenditure, not actual expenditure. What this seeks to do is measure a business’ performance against the expenditure levels historically required to achieve certain results, and neither party – vendor or buyer – is able to unfairly influence costs to their own advantage.
Top 5 Tips for Effective Earn-Outs
1. Set the governing parameters up front and include them in the contract. Keeping Murphy’s Law in mind, if you don’t cater for every conceivable outcome (good or otherwise) it will come back to bite you.
2. Avoid deals that aim to self-fund. The canny buyer will often try to sell a vendor on the concept of “I’ll give you $1m for your business, but it’s paid in instalments and only if the business makes $1m during the earn-out period”. What’s the point in taking on the transaction risk? You may as well keep the business, make the $1m and close the doors… You have to stay involved regardless!
3. Keep them as short as possible. 12-24 months are normal, and manageable under most circumstances, but any longer and it can get difficult, particularly if the relationship between vendor and buyer breaks down.
4. Include early payment triggers. Both parties almost always enter into transactions with the best intentions, but the stark post-sale reality can mean the buyer’s strategy or relationship with the vendor may change. They may want to make some material changes to the business – branding, staffing, location, etc. – so make sure you negotiate early payment triggers and include them in the contract.
5. Protect yourself. If you’re selling, you will require some assurance that the buyer is “good for it”. I have yet to see a buyer accede to a vendor’s solicitor’s request to lock away the deferred payments in an escrow account, so it’s barely worth even trying that one. However, you may be able to achieve a fixed and floating charge over the entity/assets, a bank guarantee or something similar. Insurance products also exist for vendors seeking earn-out coverage.
Remember, if you plan to sell – or buy – at some time in the future, it is highly likely that an earn-out will feature. Be fair and reasonable, set the ground rules early and get it all in writing. Don’t suffer the fate of the unprepared and see your dream transaction turn into a nightmare.
Andrew Cassin is an Exit Advisor and Business Broker licensed in Queensland, New South Wales and Victoria. His company, Acquisiti is premium business brokerage and advisory firm, providing services aimed at maximising the exit result for its clients. Andrew holds a Bachelor of Business and has pursued post-graduate studies in financial services, corporate governance, mergers & acquisitions, and change management. For more information contact Andrew via email at enquiry@acquisiti.com