An earn-out is a type of financing in which the full payout is deferred until the acquirer verifies the financial success of the business within a predetermined period of time after the closing date. An earn-out is a practical financial tool for an instance when a gap exists between the valuation price and allotted funding from the buyer. They can also be a very valuable tool when a significant client concentration exists or when the trailing twelve month’s financials are substantially above or below prior years. However, earn-out rewards may be difficult to measure when the deal involves merging two existing businesses. An earn-out is a more relevant financial option in an acquisition or divestiture.
Determining Earn-Out Value
The total payout price is determined by the success of a business under new management. The success may be measured by multiples of EBITDA, gross profit, net income, revenues, earnings per share, etc. The earn-out value can derive from a variety of achievement determiners, depending on how the agreement measures achievement. The most common variable for earn-out value determiners is calculated by future revenues. An earn-out can be paid in either installments or a lump sum at the end of the determined time period.
Benefits for Both Parties
An earn-out is a practical and useful financial strategy that is highly beneficial for both parties, but for differing reasons. Some of the ways that each party can benefit are as followse:
• The seller often receives part of the sale price up front, and then the seller will have the opportunity to earn the rest of (or sometimes even more than) the agreed-upon sale price based on the company’s continued performance.
• While the seller does not receive full cash up front, overall a seller has the opportunity to earn more than they would over time than if they had been paid in full.
• If the company in question does not meet the predetermined earn-out level, the seller will not typically lose the entire payout price.
• An earn-out allows the seller to demonstrate his or her confidence in the worth of the company.
• An earn-out helps reassure the buyer that they are receiving the best deal for their money.
• The buyer is protected against undisclosed issues that may not have arisen during due diligence.
• The buyer may have the option to pay the remaining balance with profits earned by the acquired company.
• Earn-outs can be utilized in an economy where third-party financing may be difficult to acquire.
Earn-Outs for Startups
Since many startup businesses possess a large growth potential but lack the large-scale revenue to exhibit potential, an earn-out can prove to be an advantageous financial option. Startups are often difficult to valuate because of lacking historical data, and potential is not easily measured by numbers.
It is important to note that earn-outs do not always factor in issues such as bad management by the acquirer or a changing market. These potential risks must be assessed before agreeing on earn-out payments in an M&A deal. The payout must be fully structured before both parties sign the contract. Common questions to address can include:
• “On what factor will the payout price be determined?”
• “Over what period of time will the payments be compensated?”
• “Will there be a cap on the earn-out payments?”
• “What happens if the buyer misses a payment?”
An M&A intermediary can assist both parties in astutely answering these questions and drawing up a thorough financial agreement. George & Company is happy to provide completely confidential representation to business buyers or sellers. Contact us for further information.