What is an Earn-Out When Selling a Business?
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If you’re considering selling your online business, it’s important to understand the common terms and structure of a potential deal. One term that may come up in negotiations is an earn-out.
These contractual provisions can enable sellers to receive additional payment after the acquisition, contingent on the business’s future performance. Earn-outs are commonly employed to bridge valuation gaps, manage risk, and incentivize the seller’s active role in the successful transition of the business post-acquisition.
If you’re an online business owner considering a sale, it’s crucial to understand when an earn-out might make sense and how to protect your interests under these agreements. This article covers the details of earn-outs, providing a comprehensive guide to help you navigate the challenges and capitalize on the opportunities they present.
What is an Earn-Out?
An earn-out is a contractual provision that compensates the seller if the business achieves specific goals or targets after the acquisition. If the business meets or exceeds these targets within a specified timeframe, the seller receives additional payment on top of the initial purchase price.
Earn-outs usually account for less than half of the total purchase price, with most of the payment made upfront. They are typically used in deals where there’s a difference of opinion between the buyer and seller on the value of the business or when there’s uncertainty around future performance.
Although earn-outs present a risk to the seller because of potentially not getting all of the money if the targets aren’t hit, earn-outs often make deals possible that would otherwise not happen. Additionally, earn-outs may allow the seller to achieve a higher total sales price if all of the targets are hit, as compared to a similar deal with only an upfront payment.
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Why Earn-Outs Are Common for Business Acquisitions
Earn-outs are often used in acquisitions for several reasons:
- Bridging valuation gaps: In some cases, buyers and sellers may have different opinions on the value of a business. An earn-out can bridge this gap by allowing both parties to share the risk and potential rewards.
- Managing risk: Earn-outs are also commonly used when there’s uncertainty about future performance. By tying a portion of the payment to specific targets, the buyer can mitigate risk and ensure they’re paying a fair price for the business.
- Incentivizing seller involvement: Earn-outs can incentivize the seller to remain involved in the business post-acquisition (for example, in a consulting role). This can benefit the buyer, as the seller’s knowledge and expertise can help ensure a successful transition.
Buyers like earn-outs because they help to prevent overpaying for a business that quickly declines after the acquisition. The financial risks of an acquisition can be high, and earn-outs help to manage or reduce those risks.
Example of an Earnout
Let’s say a buyer wants to buy an online business for $500,000. However, the seller believes the business is worth $600,000. Both parties may agree to an earn-out structure to bridge this gap and mitigate risk.
The buyer agrees to pay $450,000 upfront with a tiered earn-out tied to specific revenue targets for the first year after the acquisition. The seller can receive an additional $50,000, $100,000, or $150,000 if the business meets or exceeds specific revenue thresholds.
In this scenario, the seller can potentially receive the full $600,000 they feel the business is worth, but only with strong performance after the acquisition.
How Earn-Outs Can Actually Benefit Sellers
Earn-outs are often perceived as a benefit for buyers due to risk reduction, but they can also present advantages for sellers. Some potential benefits include:
- Higher total purchase price: Depending on the structure and targets of the earn-out, the seller may achieve a higher total sales price than if they only received an upfront payment.
- Larger pool of potential buyers: By including an earn-out provision, the pool of potential buyers may increase as some buyers who were hesitant due to valuation differences may now be willing to make an offer.
- Increased likelihood of finding a buyer and completing a sale: Similar to the previous point, an earn-out structure leads to more buyer demand, increasing the chances a buyer is found.
- Potential tax benefits: Depending on the earn-out structure, sellers may benefit by spreading the payment across multiple years.
Potential Risks for Sellers
While sellers have potential benefits in accepting an earn-out, it’s important to also acknowledge and protect against potential risks. Some common risks include:
- Uncertainty: Earn-outs introduce uncertainty for the seller, as their total payout depends on future performance. This can be especially concerning if the seller can no longer control or influence the business.
- Limited control over operations: As mentioned, sellers may lose control over the business after the acquisition, making it challenging to ensure that targets are met, and earn-out payments are received.
- Disputes over targets: There’s always a possibility of disagreement between the buyer and seller on whether targets were met, leading to potential disputes.
How Sellers Can Protect Themselves When Using Earn-Outs
To mitigate potential risks, sellers should take the following steps when considering an earn-out:
1. Get as Much Cash Upfront as Possible
The best way to protect yourself when using earn-outs is to negotiate for as much cash upfront as possible. This will reduce your risk and ensure you receive some payment for your business regardless of how it performs in the future.
2. Base Earn-Outs on Top-Line Revenue, Not Profit
It’s essential to base earn-outs on top-line revenue rather than profit. The buyer can manipulate profit, and verifying whether the buyer is accurately reporting their expenses is difficult. Top-line revenue, on the other hand, is easier to verify and provides a more accurate reflection of the business’s performance.
Additionally, the buyer may increase expenses and reduce profit to avoid paying higher earn-outs. This isn’t an issue if the targets are based on top-line revenue.
Erin O’Leary, M&A Advisor with BayState Business Brokers, said, “What you do not want to do is structure an earn-out based on profitability when the exiting seller has no control over the future costs of operations. Thus, if you can structure an earn-out based on top-line revenues alone (if you are getting compensated based on growth projections and trajectory), or revenues with a particular customer (if you are solving for customer concentration concerns), or product (if you are solving for high single-product reliance), it would be beneficial. Sales/revenue-based earn-outs are best as they align both parties’ interests, and can be used to bridge gaps and mitigate risks that concern the buyer.”
3. Make Sure The Targets Are Realistic
It’s important to review and negotiate the targets in the earn-out structure carefully. Targets that are too high or unrealistic will make it difficult for you to receive additional payments, even if your business is performing well.
4. Clearly Define Measurement Metrics
In addition to setting realistic targets, it’s crucial to have clear and agreed-upon measurements for those targets. This will help avoid disputes in the future.
5. Make Sure It’s Not “All or Nothing”
It’s crucial to negotiate earn-outs that are not “all or nothing.” You won’t want to entirely miss out on an earn-out payment because a target was barely missed. Instead, use tiered goals or targets, where you can still receive a portion of the earn-out even if the business doesn’t meet all targets.
6. Establish Obligations for the Buyer
To protect yourself further, you can include obligations for the buyer in the earn-out agreement. These can include maintaining certain levels of marketing or investing in the business’s growth.
7. Negotiate Higher Payments
Agreeing to an earn-out introduces risk for you as the seller, so it’s beneficial to negotiate some potential upside into the deal. For example, if all of the targets are met, you may receive a significant payout that exceeds the initial valuation of your business.
8. Negotiate a Shorter Term
The length of the earn-out period can also impact your potential risk and upside. It’s often beneficial to negotiate for a shorter term, such as one year, so you can receive your full payout sooner.
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When an Earn-Out Makes Sense for Sellers
Earn-outs can be a beneficial tool for sellers in certain situations. Some scenarios where an earn-out may make sense include:
- Valuation discrepancies: If there is a significant gap between the seller’s valuation and the buyer’s valuation, an earn-out can bridge that gap and provide both parties with some level of risk mitigation.
- Strong growth potential: If the business has strong growth potential and you’re confident it will achieve the targets or goals of the earn-out, it can be a way to capture some potential future upside.
- Lack of cash offers: If you’re not receiving many cash offers for your business, an earn-out may open up more opportunities with buyers.
- Market volatility: In a volatile market, an earn-out can provide stability for both parties by tying the payment to future performance rather than current market conditions.
- Desire for ongoing involvement: An earn-out may make it possible for you to stay involved in the business after selling.
When an Earn-Out Doesn’t Make Sense
Sometimes, an earn-out might not be the best option for you as a seller. Here are a few situations where an earn-out might not make sense:
- You want to move on quickly: If you’re looking to exit the business quickly and move on to something else, an earn-out might not be the best option.
- The business is in a volatile industry: If the business operates in an industry prone to sudden changes, an earn-out might not be the best option. It can be difficult to predict future performance, and if the earn-out targets aren’t met, you might end up with less money than you expected.
- You don’t trust the buyer: If you don’t trust the buyer to run the business properly, an earn-out might not be the best option.
- You’re not confident in the business’s future performance: If you’re not confident in the business’s ability to meet the earn-out targets, an earn-out is not the best option.
- You need the money upfront: You should avoid an earn-out if you need the money from the sale upfront and cannot wait to see if the targets are achieved.
In these situations, it might be better to negotiate a different type of deal with the buyer.
Final Thoughts on Earn-Outs
Earn-outs can be a helpful tool for sellers to bridge valuation gaps and capture potential future upside. However, they also come with risks and should be carefully considered and negotiated.
By following the tips outlined above, you can protect yourself as a seller when using earn-outs and potentially maximize your payout from the sale of your business.
