Not All Earn-outs Are Equal: How to Identify & Evaluate Them All

During the process of selling your business, the night before Indications of Interest are due is probably a sleepless one. Business owners with dollar signs dancing in their heads find it difficult to sleep awaiting the offer emails that tomorrow will bring.  Along with those offers you might encounter some value placed in an earn-out.

Earn-outs are not necessarily a problem, although sometimes they can be difficult to manage. I describe an earn-out and some of the difficulties you can encounter in an earlier blog post. It is important to remember that all earn-outs are essentially a risk allocation vehicle.

If you have gotten to a point in a transaction where an earn-out is inevitable, here are a couple of ways to think about them.

Most Common: An Earn-out to Bridge Valuation Gaps

If you think your business is worth $30 million and a buyer, who is great in all other aspects, thinks your business is worth $25 million, you might be tempted to throw your hands up exasperated and walk away from the deal.  

One way a buyer can bridge a valuation gap like this is to utilize an earn-out. They are effectively saying, “I don’t think the value of the company is $30 million right now, but maybe it will be in the future, and if that happens, I would be willing to share some of that value with you, Ms. Seller.”  

The earn-out in these situations is structured so that you share in some part of the income statement (revenue, gross profit, earnings) until you get to the $30 million price tag. These are nice in that it’s a way for you to take the majority of your chips off the table AND get the price you wanted – albeit with some additional risk.  

I’m sure you can see some of  the problems that can occur with this set up.  

1.  What happens if your buyer runs the business into the ground?

2.  What happens if the buyer fires the best salesperson?

And an even more tricky situation,

3.  What happens if the growth you were expecting requires some investment on the part of the buyer and they are unwilling (or unable) to make it?

The Lottery Ticket:  An Earn-out That Offers a Seller Some Additional Upside

A slightly different version of this story can occur when you think your business is worth $30 million, the buyer thinks the business is worth $25 million, and gives you an earn-out with unlimited upside potential.  In this case, you have the ability to make up the valuation difference and perhaps more.

These are interesting because they bridge the valuation gap – like our first example – but they also offer the seller a lottery ticket of sorts.  Along with the potential for greater upside, these earn-outs are not immune from the pitfalls of the earn-outs outlined above.

Got Cash?:  Earn-out as a Form of Seller Financing

There is a distinct difference between a valuation gap because of differing views on the company and its growth trajectory and a valuation gap because the buyer can’t pay any more money. We tend to see this more when traditional financing gets tight or interest rates are very high.  

Play Nice!:  Earn-out to Make Sure the Seller Cooperates

Earn-outs can be a very effective way to make sure that a seller is going to provide full cooperation in transitioning the business. This can include things like transitioning customers, files, etc. to a new building.  

If you sign up for one of these, make sure the dollar amounts (remember they are risky) here commensurate with the amount of transition that really needs to happen.  Also – make sure that the transitioning you are being asked to do is something you can control.  You don’t want $5 million of your dollars on the hook for a transition to a new warehouse when you don’t control the move.  

Let’s Pretend That’s Not a Thing:  An Earn-out to Make Things Move More Quickly

If for some reason your transaction is stalled – for a bad reason or good reason – an earn-out can be used to close in the face of uncertainty. If you might be the victim of a giant lawsuit, a buyer can allocate risk back to the seller by paying a smaller price upfront and the rest in an earn-out paid over several years, which can give them time to see how the lawsuit goes. 

If you are on the verge of closing a life-changing $100 million new customer, but still want to sell your business today (not sure this is a good idea, but I can think of some times when this might be the case), a buyer can pay you what the business is worth now and agree to share upside with you later with an earn-out.

In my many years as a transaction advisor, I try to steer away from earn-outs whenever I can. They can represent large dollar amounts which tend to lead to large emotions, weird motivations, and expensive lawsuits. If you go into the situation understanding that allocation of risk, and pricing that risk appropriately in your mind when negotiating, there are times when earn-outs can be a transaction facilitator.