This is the third in a series of posts discussing the sale of a business from the seller’s perspective. In the first and second posts, we provided an introduction to this series and discussed the difference between asset and stock sales and some of the considerations and pitfalls when providing seller financing. In this third post, we’ll discuss another common deal structure issue, earn-outs.
An “earn-out” is a deal structure whereby a portion of the purchase price is contingent on the purchased business achieving some pre-determined goal after closing. Common earn-out terms are attainment of certain revenues or EBITDA by the purchased business in the year or two after closing. Earn-outs are common when a buyer and seller aren’t quite in agreement on valuation. For example, the seller wants $5 million and is confident post-closing financial performance will support such a price but the buyer is skeptical and thus only willing to pay $4 million at closing. An earn-out might bridge the gap in this example with the buyer paying $4 million at closing and agreeing to pay another $1 million (or more) if post-closing performance proves to be as the seller claims it will be. Earn-outs add significant risk and complexity to deals from the seller’s standpoint and need to be thoroughly evaluated. Here are a few issues to consider:
Term — from the seller’s point of view, earn-outs should generally be structured with relatively short terms, often no more than two to three years, and many times much shorter periods.
Top Line or Bottom Line — earn-outs can be tied to any financial (or non-financial) measure, but common alternatives are revenues or adjusted EBITDA. Revenues are generally less prone to producing disputes because they are much easier to measure. Adjusted EBITDA, on the other hand, can be very tricky and needs to be very carefully considered. As a seller, with an EBITDA measure, you need to focus on what expenses the buyer might incur that could be detrimental to attainment of the EBITDA target. It could certainly be the case that the buyer may want to take actions or incur expenses that it believes are in the best long-term interests of the purchased business even if it hurts EBITDA in the short run. Be aware of this potential and consider requiring covenants from the buyer that will it use reasonable efforts to help the business hit the earn-out targets. Discuss the buyer’s plans for the business after the transaction and try to determine if there are planned activities that might result in needed adjustments to EBITDA after the closing.
Control — as a seller, your ability to control or influence the business and its results will be substantially reduced (if not eliminated) at the closing and any post-closing control or influence you have will likely diminish quickly. However, if you will be staying on with the business with the buyer (perhaps as an officer or consultant) for some period of time, then you may have some ability to influence the business’s results. Think carefully about how much influence you may have on the earn-out hurdle (as an officer and consultant) and how important this is to you as the seller. Many sellers will only be comfortable with an earn-out if they are running the show during the period in which the earn-out is to be measured.
Stand Alone Business or Division — will the purchased business be a stand-alone business post-closing or will it be incorporated into a larger business? If it’s going to be part of another business, then there are more questions and the earn-out process will likely be more complicated. Will it be tied to the overall business or just the purchased business? How will financial results of the earn-out business be separated from the larger business? How will corporate overhead be allocated to the earn-out business? Will there be audited financial statements for the earn-out business or not?
Dispute Process — make sure your deal documents include a dispute resolution process. As a seller, you want to make sure you have the right to review and inspect the buyer’s financial records post-closing to evaluate whether or not the earn-out hurdle was achieved. And there should be some sort of dispute process, such as giving the seller the right to have an independent CPA firm review the financial results of the earn-out business.
Payment Terms — if the earn-out amount (when determined) is not paid in a lump sum, then the seller will bear the same risks with respect to the earn-out payments as with a seller financing.
Other Terms — what if the buyer sells the earn-out business before the earn-out amount is attained? Should this result in some portion of the earn-out being automatically earned and payable? What if there is a change in management (e.g., as seller, you’re comfortable with the current CEO but he’s replaced with a new CEO during the earn-out period)?
As with seller financing, earn-outs add significant risk and complexity to a sale of business transaction. A prepared seller will give significant thought to any earn-out terms very early in the deal process and consider ways to maximize earn-out success in the context of the specific business.
In the next post, we’ll discuss letters of intent and then move into the due diligence process.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
