What is an Earn-out?

We're emerging from a recession and earnings have been slightly (or more than slightly) down over the past few years. Sellers know they have a great business and that it will rebound in the coming years. Buyers get that vision, but aren't willing to pay for it up front. Therein lays the "valuation gap."

One way to bridge this gap is simply for the seller to wait for the value to go up. For those sellers ready to sell now, the gap can be closed through an earn-out. In an earn-out, a portion of the purchase price is contingent upon the business reaching certain milestones. If the milestones are met, the seller shares in the upside. If the milestones are not met, the buyer hasn't paid for an increased value that never came.

For example, Charlie owns a $400,000 machine shop that supplies automobile parts. Charlie knows that orders and sales are going to increase over the next few years as the economy recovers and his clients start ordering more parts. Because of this future value, Charlie wants to sell his business for $500,000. Joe wants to buy Charlie's machine shop and agrees that the business will likely grow substantially over the next five years, but doesn't want to pay $100,000 for sales that may never materialize....

Joe offers Charlie $400,000 for the business plus an additional $50,000/year for the next five years if certain revenue thresholds are met. Charlie agrees to the deal because he is confident that Joe will achieve those thresholds and he believes that he will make more money in the long run. The buyer and seller have successfully used an earn-out to bridge the gap.

From Joe's perspective, the earn-out gives Charlie an incentive to help the machine shop continue to grow after the sale. It also makes the deal more bankable since less money is needed at closing.

From Charlie's perspective, he has a chance to make more money...but only if the business (which he no longer controls) performs as well as Joe says it will. He needs to be realistic about expected future performance and also needs to make sure that the agreement is very clear about what will trigger his payouts - a misunderstanding could get messy.

As a rule of thumb, earn-outs can be anywhere from 10 - 35% of the selling price. They are particularly helpful when a seller argues that the historical financial results are not indicative of future potential. They also work well when a business has just launched a new product line or the business is relatively new and has yet to reach its potential.