You have a great business - it’s growing 15% year over year and you’re optimistic.
You’ve decided to sell, but your broker is telling you to maximize the sale price it might require an earn-out - an earn-out contingent on your business growing 15% each year after the sale.
Once your broker tells you that an earn-out is a portion of the sales price you will only receive if the business reaches that goal, you may become worried and ask:
What if the buyer is a bad fit and sales decline?
What if the market turns or something happens beyond your control?
These are reasonable concerns and can be valuable in directing how your attorney and broker structure the earn-out.
At MidStreet Mergers & Acquisitions, around 10% of the deals we perform require an earn-out. We have helped countless business owners structure their sale to include one that they are comfortable with and feel confident they can achieve.
To help you learn what an earn-out is, this blog will discuss what it is, how it works, and how you can increase your chance of getting your full earn-out.
1. What is an Earn-Out?
An earn-out is a portion of the sales price that is contingent on a performance factor being achieved after the sale, such as the business reaching certain revenue levels or retaining a certain percentage of employees.
The seller may feel that their business is worth a certain amount based on past growth that they believe will continue. If the buyer is unsure that the business will grow as much as the seller anticipates, the buyer may propose an earn-out to cover the difference in perceived value.
By doing this, the buyer is essentially communicating “I believe you, so I am willing to share a piece of the pie if things go well. However, I am holding onto this money (the earn-out) in the case that they don’t go well.”
2. How Does an Earn-Out Work?
An earn-out will have set conditions that need to be met within a specific timeframe. If those conditions are met, the seller will receive the earn-out.
Some earn-outs will be set up in tiers. The tiers will each have a set timeline and at the end of each tier, the seller will receive a portion of their earn-out if the goal is reached.
Some examples of what an earn-out could look like are:
Example 1: You earn $100,000 if the business does more than $4,000,000 in revenue.
Example 2: You earn $10,000 for every $50,000 in revenue above $3,000,000.
Typically the earnout is based on a baseline year which is most often the last 12 months or the last full year. It can be month to month as well, where you get paid based on a percentage of growth over the same month the last year.
The amount/percentage of an earn-out can vary between each business sale, but on average, an earn-out usually makes up 10-30% of the sales price.
3. What Is The Average Length of Time For an Earn-Out?
An earn-out can have a term anywhere between six months to 2 years. However, as deals get bigger, the term can get longer.
The length of the earn-out should be long enough so that the goal of the earn-out can be realistically achieved. For instance, if you expect that the business will reach a certain revenue level in the next one to two years, having a term of only six months would be too short.
As a seller, you will also not want to pick a term that is too long because:
- You would need to wait longer to receive the earn-out
- The company’s performance will be out of your control in the next few years
By creating a realistic term for the earn-out, a seller will be able to have a good chance of receiving a portion of the future profit they helped create.
4. Can The Seller Set Clauses to Protect Their Earn-Out?
Yes, the seller can set clauses to protect the earn-out. As a seller, you will want wording that limits your liability if the buyer makes changes that adversely affect the performance metric your earnout is tied to.
For example, if your earn-out is tied to employees staying on after the sale, then the wording might specify employees terminated by the new owner don’t count.
Our advice is to base any earn-out on revenue or a defined formula and not profit or cash flow. Profit or cash flow can be easily manipulated to look worse on paper, reducing the amount the buyer has to pay.
Other tangible metrics like employee, customer, or supplier retention are also acceptable with the proper wording from your attorney.
5. Do You Have to Do an Earn-Out?
In the lower middle market ($1 - $25 million in revenue) most deals do not involve an earn-out component. They are typically reserved for deals with higher uncertainty, such as companies with rapidly growing sales or a new location that is expected to grow sales.
As an alternative to an earn-out you could offer seller financing, if your company has a stable track record. Seller financing accomplishes a lot of the same things an earn-out does but the buyer is required to pay it.
If you have a deal that does warrant an earn-out, we recommend that you consider the earn-out as gravy. This means it's something that would be nice to have but your still satisfied with the price if it does not.
Decide If You Need to Do an Earn-Out For Your Business Sale
Now that you know what an earn-out is, how it works, and how you can protect yours, you will be able to determine if you are comfortable with an earn-out.
Ultimately, as the seller, you get to decide if you want to do an earn-out or not. However, your merger and acquisition advisor may suggest that you do one if your company is projected to grow, but it can’t be justified 100% in the sale price.
Another way you can maximize your profit when selling your business is to learn about the costs associated with selling your company. Check out our blog “How Much Does it Cost to Sell Your Business?” to minimize the cost of selling your business.
If you are thinking about selling your business and want to know if you will need to do an earn-out, give us a call today.