Earn-Outs in Business Sale Agreements

An earn-out is a financial arrangement in the sale of a business by which the seller can earn additional payments – increasing purchase price - based on the future performance of the business being sold. Simply put, instead of receiving all the purchase price up-front, the seller is paid more if the business meets certain financial targets in the future.

How Does an Earn-Out Work?

Imagine you are selling a lemonade stand. You believe it is worth $100, but the buyer thinks it is worth $70. Instead of walking away from the deal, you both agree that the buyer will pay you $70 now, and if the lemonade stand makes more than $50 in profits next summer, you will get an extra $30.

Why Include an Earn-Out in a Purchase Agreement?

1. Bridge Valuation Gaps: Often, buyers and sellers have different views on the value of a business. An earn-out can help bridge this gap, allowing the deal to move forward.
2. Reduce Buyer’s Risk: Earn-outs can lower the upfront cost and risk for the buyer. They only pay the full price if the business performs as expected or better.
3. Motivate the Seller: If the seller remains involved in the business, an earn-out can act as an incentive for the seller to ensure the business continues to succeed.
4. Facilitate Financing: Buyers may find it easier to finance the purchase of a business when a portion of the price is based on future performance. Lenders might view the transaction as less risky with more “skin in the game.”

Considerations for Earn-Outs:

• Clear Targets: It is crucial to set clear, measurable targets (e.g., revenue, profit margins) to determine the earn-out payment.
• Duration: How long is the earn-out period? It could range from months to several years.
• Disputes: Given the future-based nature of earn-outs, disputes can arise. Clear language on resolving disagreements is a critical part of an earn out.
• Involvement of Seller: To what extent will the seller be involved in the business during the earn-out period? Their role and decision-making power should be clear.

Takeaway:

An earn-out can be a beneficial tool in the sale of a business, helping to address differences in valuation and reduce risk. However, like all agreements, ensuring all terms are clear and that both parties understand their obligations and rights is crucial.

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