Structuring an Earn-Out Agreement When Selling Your Business
I make sure all my clients go into an earn-out agreement with eyes wide open. The fact is, earn-outs are a common point of contention after a sale. So I also strongly urge clients to build in a process for dispute resolution. Also, be wary of buyers who try to make the seller shoulder normal business risk through an earn-out. This is why it is crucial to have advisors who will have your back and make sure the buyer assumes reasonable risk.
Here are some elements to consider when structuring an earn-out agreement:
1. Determination. The first step in structuring an earn-out is determining if it is appropriate for your situation. For example, if the buyer plans to leave your company as a stand-alone business after the closing, a profit or performance-based earn-out may be reasonable. On the other hand, if the buyer intends to merge or integrate the company with other businesses after closing, that may not be the best situation for agreeing to an earn-out because your ability to influence performance will be greatly minimized. As a general rule, earn-outs are supposed to be win-win scenarios benefitting both buyer and seller, so make sure you are given the freedom and authority you need to achieve the performance targets for your earn-out.
2. Amount. The amount of the earn-out depends on how much risk the buyer faces. Normally, the earn-out amount is around twenty to thirty percent. However, a buyer purchasing a business with higher risk could command a significantly higher earn-out percentage
3. Terms. In my experience, earn-out periods can be as short as one year or as long as five; usually, the shorter the term the better for the seller. So, negotiate an earn-out time frame that you are comfortable with.
4. Measurement. Many buyers will want to base the earn-out on EBITDA (earnings before interest, taxes, depreciation, and amortization). From the seller’s perspective, the problem is that since they won’t be in charge, they won’t have control over the EBITDA. A safer way to go is to base earn-outs on revenue milestones or gross margins. The simpler and more clear-cut the better. It’s not uncommon to see earn-out formulas that look like a complex mathematical equation. For the seller, earn-outs work out the best when payout is based upon one or two simple variables. Don’t let a buyer make it so complicated that it becomes almost impossible to achieve your earn-out.
5. Conditions. Be sure you include priorities you believe are essential to meeting your earn-out goals. For example, have a condition that your key managers are not replaced. If you are staying with the company, put it in writing that you will oversee the departments on which your earn-out depends. Do not let the buyer dictate these kinds of conditions, which can impair your ability to perform and hence collect your earn-out.
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