What is an earn out and when to use

In negotiations the Seller wants to see an as high value for his business as possible, whereas a Buyer prefers a low value. When both parties are unable to reach an agreement on the price a middle-way could still bring the deal to a success. Here is where the earn out arrangement comes in.

What is an earn out?

An earn out is a legal arrangement between Seller and Buyer stating that an additional compensation is paid by the Buyer to the Seller if certain financial conditions are realized in the future.

The earn out amount could be a portion of the purchase price or an additional amount. The objective of the earn out is to bridge the price expectation gap between Seller and Buyer. The Buyer will be willing to pay the earn out amount, as it is linked to actual future financial performance of the business. Also, it ensures that the Seller keeps being involved and active in the Company post-acquisition.

The amount can be fixed or a percentage of a financial metric (e.g., revenues, gross profit or EBITDA). For example, the Seller is entitled to a payment of $1,000 if next year revenues amount to $10,000 or higher. The terms of the earn out are dependent on negotiation between Buyer and Seller. Often it is linked to the business plan prepared by the Seller. The reasoning being that if the Sellers feel sufficient confident about its business plan they should have no issue in making a portion of the purchase price conditional on the realization of the business plan.

While an earn out sounds great in theory, in practice it is not advisable and often results in disputes.

When to use?

While an earn out sounds great in theory, in practice it is not advisable for a Seller. An earn out very often leads to disputes between Buyer and Seller. As a Seller you need to realize you are no longer the owner of your business post-acquisition. However, you still will be responsible for the achievement of the budget, while not having control of the Company. For example, what happens if the new owner decides to limit the marketing budget, but you agreed an earn-out based on future revenues. Or what if you have a disagreement with the new owners and you are fired? Even accounting can play a role. After acquisition the business has to follow the accounting guidelines of the Buyer. These could have an impact on how revenue or profit is calculated.

For a Buyer there are also disadvantages. Normally, directly after acquisition the Buyer starts to integrate the acquired business into its own businesses. However, if there is an earn out this could prove difficult. How will the earn out target be calculated and measured if the original business does no longer exist and is completely integrated within another business. If the Buyer wants to sell its own products through the distribution channels of the acquired company, will the resulting revenues of these sales count toward the earn out of the Seller?

In the case an earn out arrangement is used, make sure to limit the earn out period to a as short time as possible. Also, make sure that you as an owner post-acquisition have sufficient authority to ensure realization of the earn out target.

What to consider when applying?

The following considerations are important when setting an earn out:

What is the earn out target? Make sure you set an objective and clear financial metric.
How will the target be measured? Try to be as detailed as possible, mention which accounting principles need be followed (GAAP), and in the case of using EBITDA or gross profit which accounts need be summed to calculate the number.
What is the timeline? Link the timeline to an accounting date, for example quarterly or yearly fiscal ends.
How will the amount be paid out? Will this be in cash or perhaps shares in the new Company? Will the amount be kept in an escrow for now?
What will happen if the Seller gets fired? If fired for whatever reason do you get the full amount as if the earn out would be realized?
What will happen if the earn out target is not realized? If you just missed the earn out target, do you receive nothing or still a portion of the earn out amount?

Deferred payment

Another form of Buyer and Seller reaching agreement is a deferred payment or acquisition of only a portion of the shares while receiving an option to acquire the remainder of the shares in the future.

A deferred consideration or deferred payment differs from an earn out as it is not conditional. The amount has to be paid in the future no matter what. This arrangement could help Buyers which do not have sufficient liquidity to pay the full purchase price right away. In a deferred payment the Seller generally does not remain active in the business as an in that case an earn out arrangement makes more sense.

While the above considerations could help in bridging the price expectation gap between the Seller and Buyer, as a Seller always try to get the full purchase price paid when the acquisition is performed. A deferred payment or earn out always brings liquidity risks (e.g., bankruptcy of the Buyer). Where possible, try to get the deferred portion of the purchase price paid to an escrow account to limit this risk.

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