How to Avoid Common Earn-Out Mistakes

An earn-out is a form of M&A financing in which the seller receives a full payout only after specific provisions have been met within a set amount of time after the deal is closed. Typically, the seller collects a smaller sum at the close, and then has the opportunity to earn more based on the company’s forward progress. An earn-out helps protect the buyer from any hidden problems such as client concentration, as well as allows the seller a higher price than they would otherwise if the buyer paid the entire purchase price up front.

Unfortunately, an earn-out has the ability to become complicated if not performed properly on both sides of the deal. The following describes the most common earn-out mistakes and ways in which a seller can avoid them.

Set Realistic Expectations

Perhaps the most common reason that an earn-out fails to benefit the seller is because of an unrealistic goal that has been set for the specific earn-out period. The buyer and seller may have differing opinions on what makes an appropriate goal. In fact, it is quite uncommon for the actual results of an M&A deal to coincide with the objectives set.

Help prevent the buyer from setting unrealistic expectations by utilizing a professional business appraiser that can set a realistic value for the company and can assist in drawing up the final contract. Many times the appraiser will utilize a discounted future earnings approach to set expectations for the earn-out. It is important for the seller to create incentives for the buyer to assist them in reaching the proposed goals and keep them focused on short-term objectives.

Short Term Goals of the Earn-Out Period

Oftentimes, a savvy buyer will purchase a company and then implement a successful long-term business plan. This long-term plan may be effective over an extended period of time, but the buyer may need to borrow financing from other parts of the business in the short-term. This method has the ability to decrease the overall profits during the first few years, causing the seller to lose out on receiving the full earn-out payback. In this scenario, the business appears to have lost revenue during the earn-out period, when in reality the company is performing well.

In order to prevent such a situation, the final contract must hold additional restrictions and use language that allows for exceptions. One manner in which the seller can avoid being cheated out of warranted capital is to place constraints on the implementation of long-term plans during the earn-out period. One boundary may include disallowing the buyer to apply any drastic changes (such as letting go of key employees or repositioning funds) until the earn-out period has ended. Retaining the basic structure of the business is important. Also, be sure to create a contingency plan in case any outside factors negatively affect the business.

Are you looking for advice on how an earn-out can impact the sale of your business? Please contact George & Company. We are experienced M&A professionals and we would be happy to confidentially assist you in the successful sale of your business.