Earn-Out Risk Factors In a Business Sale

An earn-out agreement is all about performance and managing risk. More specifically, it is about the future performance of your company after it’s sold. In certain instances a buyer will negotiate to defer part of the sale price to a payment contingent on the company’s continued performance. Earn-outs are often established when the owner retains a position with the business post-sale. In that scenario, earn-outs become an incentive, for the original owner, to make sure the company’s performance maintains or improves.

Practically speaking, an earn-out hedges the buyer’s bet. All companies have inherent risks, some more than others. The greater that risk, the more likely a buyer will request an earn-out clause. As a general rule of thumb, if the risk is considered standard and the seller is not staying with the company, in some capacity, the sale price should not depend on an earn-out.

Here are some risk factors that may lead to a buyer requesting an earn-out:

1. Owner influence. Owners who use their know-how and vision to establish effective systems and put together quality management teams have positioned their company for a smooth transition when they leave and minimize the risk that the company’s performance will suffer after the sale. However, if a buyer isn’t fully confident in the systems or that the company will maintain its performance once the owner leaves, they may negotiate an earn-out as part of the sale. Generally speaking, the earn-out amount tends to equal the difference between the seller’s asking price and what the buyer feels comfortable paying. I advise my clients to make sure they get what they feel is fair value at closing and to consider the earn-out a bonus.

2. Sales concentration. For a start-up, landing a big client is a good thing. But long-term sustainable growth demands more diversity. So if a potential buyer has concerns because your sales seem to be concentrated with a handful of clients, they will most likely want an earn-out. Similarly, if your company is dependent on just one or two suppliers for the bulk of your sales—especially if they could not be easily replaced—that also increases the odds the buyer will want to have an earn-out.

3. Instability. If you are selling from a position of weakness—the owner suddenly took ill or died with no succession in place, the industry you are in is changing or slumping, key employees have recently departed leaving a management vacuum—the buyer is assuming greater risk and will more than likely want to structure an earn-out.

4. Inconsistent earnings. As far as buyers are concerned, the numbers speak for themselves. A company with a stable earnings history and a reasonable earnings projection inspires confidence in a buyer and reflects lower risk. But if your sales over the past three years have been inconsistent and earnings projections seem overly optimistic or unreachable, the buyer’s perceived risk increases so sellers may be subject to an earn-out.

We help business owners prepare their business for a maximum value sale and can generally identify and rectify risk factors, hence minimizing the potential for an earn-out. Knowing your company’s risk factors can help you better prepare for selling your business and improve sale price.

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