Imagine if the purchase price of a business varied depending on its financial performance after you agreed to the sale.
That is what an “earn-out” is
It allows the purchase to be paid for from future cash flow and is often used if a buyer cannot get finance for the purchase in full or indeed if the buyer and seller can both agree that the purchase price should be determined by future factors, such as performance.
Purchase price is usually divided into an agreed lump sum, followed by any future earn-out amounts, calculated based on the profit of the business for a period of time after the completion of the sale.
The earn-out amount can be determined by factors such as the number of new clients or amount of products and services sold.
For more on the pros and cons of earn-outs, see CrestLegal.com
Earn-outs can have their benefits to both buyer and seller.
The buyer can benefit by deferring the purchase price and reducing any dependency on third party financing to raise enough cash.
The seller could be a beneficiary of this by agreeing to a higher overall purchase price (dependent on the agreed factors).
The business will be more accurately valued as the purchase price will be based on performance at the time rather than on past performance or future predictions.
The buyer is therefore protected from overpaying in one transaction and the seller receives a price that is not discounted due to any concerns.
There are also a number of of disadvantages of an earn-out including;
The chances of a clean break are reduced. As the buyer you would have restrictions on what can and can’t be done to the business during the earn-out period.
If a buyer has financial difficulties after the sale then the seller may not receive the agreed amount.
There may be a conflict of interest between the seller and the buyer during the earn-out period.
For example, the seller may focus on achieving targets to the detriment of other areas of the business, in order to receive as much as possible.
If the buyer is managing the business, there may also be a temptation not to reach the same targets, to reduce the earn-out amount.
Drafting an Earn-Out
Failure to draft an earn out agreement properly can lead to a number of pitfalls for both the buyer and the seller. You should;
- Ensure you have a procedure for any disputes
- Set out a clear agreement between both parties on how any metrics will be calculated. This will reduce the chances of any misunderstandings.