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There are a number of options for financing an acquisition. Many M&A deals will utilize an earn-out to cover a portion of the cost of the business, since it acts as an opportunity for the seller to close the gap between perceived value and actual paid value. If the business performs well for the buyer after the close, then the seller has the opportunity to earn more, contingent on certain provisions being met within the given period. Many sellers will opt for earn-out financing when the buyer will not meet their asking price, because it allows them to prove their confidence to the buyer and earn more in the future.
However, earn-outs can often become tricky, and some sellers do not find them to be beneficial. Here are a few tactics to help avoid these mistakes and maximize the total earn-out.
Earn-outs have the potential to become quite complicated, since there are so many different provisions that may be included. One way to work towards a higher earn-out is to draft a contract that is as simple as possible. The more concise the document, the easier it will be for both parties to follow and the more likely the buyer will be to meet the specifications.
On the other hand, do not leave out important details for simplicity’s sake. It is essential to have a balance between detail and complication. Leaving too many clauses up to interpretation can cause trouble in the future if the document needs to be reviewed due to a dispute. Be specific, but don’t set too many requirements for fulfilment either.
A shorter earn-out period could mean that the seller will earn less due to unforeseen circumstances and the buyer’s short-term decisions. For example, there may be a learning curve for the new owner which could cause profits to drop for a short time, and this will be reflected in the seller’s earn-out if an adequate period of time is not provided. With a longer earn-out period, the business will have a better chance at proving to the buyer that it was a worthwhile investment. Anywhere between eighteen months and five years will show the seller much less risk than a shorter earn-out period.
Arbitration procedures should be established in order to thoroughly prepare for any future disputes that may arise. Unfortunately, the most common causes for post-acquisition disagreements are derived from earn-out disputes. Choose an independent arbitrator so that bias is less likely to be an issue. Pre-establish an outline of actions to take should there be a breach of contract.
When drawing up the earn-out documents, make sure to include an acceleration clause, which will end the contract immediately and require full payment should there be a breach in terms. A breach includes any actions that a buyer may take that negatively affects their ability to satisfy the terms on which the earn-out is based, such as reselling the company or firing key personnel. Also, if the buyer stops making payments and therefore breaks the contract, then they are required to give the full earn-out amount owed to the seller immediately under the acceleration clause.
It is important to establish how control of the company will be handled after the close. Sometimes the seller will still maintain decision-making power over the business post-closing, which helps to prevent the buyer from conducting the business in a way that would negatively affect the earn-out. The buyer should be given requirements to use everything in their power to maximize the earn-out. Allowing the seller greater control over the business gives them more control over the quality of the earn-out as well. It will also help to prevent the seller from feeling like the buyer has made decisions that hinder their ability to maximize their earn-out.
Fortunately, getting the buyer to agree with this goal should not be difficult. The earn-out size is dependent on the success of the business, so it becomes a win-win situation. However, the buyer will also want to protect their newly acquired business from rash, short-term decisions that a seller might make in order to increase their payout but meanwhile hinders the business’s long-term growth. An agreement will need to be reached that will be beneficial to both the buyer and seller.
Earn-out calculations are usually prepared by the buyer and his or her accountant. It is imperative that the seller review all payments and statements with his or her own accountant in order to check for accuracy. Any incongruities may be challenged. An earn-out can be a great compromise between buyer and seller, as long as the above pieces of advice are followed.
Another way to assure that you are creating and executing the earn-out in the correct manner is to hire an M&A intermediary to facilitate the deal. They will be able to assist with all facets of the process, including post-closing dealings and earn-out structure. Contact George & Company today to learn more about how our M&A intermediaries can benefit your M&A process.