The ultimate guide to structuring an earn-out
The sale of your business is the most important deal you’ll ever negotiate.
Because there’s so much on the table, it’s bound to be one of the toughest as well.
And given how uncertain the market is going to be long after the coronavirus pandemic is over, it’s going to be even harder to get what you think your business is worth as part of your exit strategy.
And when you and a potential buyer don’t see eye-to-eye on how much your business is worth, they’re likely to put an earn-out on the table.
Here’s everything you need to know about the realities of taking an earn-out deal, why I advise my clients to never take them, and what you can do to avoid one entirely.
What is an earn-out?
If you think your business is worth more than a buyer, you can compromise with an earn-out – an exit where you get an upfront sum for your business, plus a percentage of its earnings for a handful of years after the sale goes through.
For example, an acquirer might pay you $1 million upfront for your business, plus 5% of its gross sales over the next three years. Or they might pay you 50% of your asking price straight away with the remaining half paid out over the next five years if the business hits certain financial targets.
This reduces the risk involved in buying your business for the acquirer while still theoretically netting you the full amount of what you business is worth over time.
A buyer will usually insist that you stay on at the helm of your business in an earn-out deal to protect themselves from the prospect of your business stumbling as soon as you’re out of the picture. The less work you’ve done removing yourself from your business’ daily operations, the more likely a buyer is to insist you stay on in an earn-out deal.
Earn-outs are common for service businesses and new companies. They last three years on average, but can last up to seven.
Earn-out payments are usually tied to hitting revenue or profit targets in the future, but can be tied to the retention of specific customers or any other objective you agree with the buyer.
The good, the bad, and the ugly of an earn-out acquisition
If you can’t find a buyer who sees eye-to-eye with you on the price of your business then an earn-out deal can certainly help bridge that gap.
The opportunity to profit from the future growth of your business in the hands of a new owner is attractive as well. Working alongside the new owner to achieve or exceed a certain level of performance means you could earn a much larger profit from the sale of your business.
An earn-out is ideal for an acquirer as well, as it protects them from overpaying for your company. If your business doesn’t perform in line with expectations, they simply pay less.
From a buyer’s point of view, it’s also an effective way of smoothly transitioning the business to a new owner. Acquirers will be keen to lock you in to an earn-out that’s contingent on you staying on as the leader if you’re the business’s owner-operator rather than CEO.
An earn-out can certainly help get you and a buyer on the same page about what your business is worth.
But what it’s crucial to understand is that you might never see money locked up in earn-out clauses. I can tell you that from hard-earned personal experience.
And if you agree to stay on and lead your business during the earn-out period, you have to work as the new owner’s employee in order to be paid what you think your business is worth.
Not exactly why we all became entrepreneurs in the first place…
Don’t get me wrong – sometimes earn-outs work spectacularly well for both parties.
However, there are plenty of examples of the seller leaving without ever realizing their full earn-out – including me.
The fact is: you’re taking a huge risk when getting paid what you want for the keys to your castle depends on future conditions for two reasons.
The first is that you're leaving the biggest sum you’re ever likely to see in fate’s hands. What if your industry tanks or a pandemic hits during the earn-out period?
I dread to think of all the entrepreneurs who’s earn-out payments are tied to numbers that are now a pipe dream because of the pandemic.
But without a doubt the worst thing about entering an earn-out deal is that your new boss has little incentive to help you hit your earn-out goals.
And once they’re the one in charge, they can change the goalposts at any time.
For example, you lose control of the profit and loss statement when you sell. That means the buyer now controls how they choose to express your profits and what expenses they decide to allocate to your numbers.
Which means they could arbitrarily apply expenses to your P&L closing to keep you from triggering your earn-out.
While you can make sure your lawyer structures your deal to protect you from having the rug pulled from under you like this, there are no guarantees.
And of course, there are plenty of buyers out there who wouldn’t dream of being so unscrupulous.
But the fact remains that as soon as you enter into an earn-out deal, you’re putting yourself at serious risk of ever seeing the capital tied up in earn-out payments.
When an earn-out can work
As a general rule, you should avoid an earn-out acquisition at all costs when you’re navigating your exit strategy.
But if you’re short of options – either because you haven't put in the work to build a valuable business or you’re in a buyer’s market – an earn-out can make sense if it ticks all these boxes:
You’re in the driver’s seat
First, an earn-out acquisition can work if you’re going to be left to run the show on your own terms.
But beware: unless you have the buyer’s commitment to leave things largely unchanged in writing, don’t be surprised when things don’t work out the way you’d imagined.
You’re comfortable with how things add up
Before you enter an earn-out deal you should insist on getting a clear understanding of how the acquiring company will fold your admin functions into their back office, what marketing expenses will be assigned to your business, and the shared management fees that will eat into your revenue. Make sure you're comfortable with all of this before you sign on the dotted line.
You remain as independent as possible
As far as possible, make sure that any part of your business that can be run independently is kept at arm’s length from the acquiring company’s infrastructure. This will ensure you have as much of a say in things as possible.
Your measured by a reasonable metric
Try to make sure your earn-out is triggered by something other than financial performance.
I know of one entrepreneur that structured their earn-out based on delivering a certain amount of software features over a six month period – a metric they had far more direct control over than revenue or profit.
You get a third party to audit the earn-out accounts and results
And consider having an external third party audit the earn-out accounts and results. This will cost you a pretty penny, but it’s far better to be safe than sorry when it comes to the biggest negotiation of your life.
The smart way to structure an earn-out
The best approach to structuring an earn-out is to not have one at all.
But if you can enter one that ticks all the right boxes and you don’t have another offer on the table, then here’s the smart way to structure the acquisition:
Know what you want
John Warrillow really hits the nail on the head in his book The Art of Selling Your Business, in which he suggests you “treat the portion of your offer locked up in an earn-out as gravy: nice if you get it, but think twice before agreeing to a deal where the original cash at close does not meet your minimum number.”
With this in mind, it’s important to get clear on two things:
- The maximum time and money you’re prepared to commit to helping the acquirer make the most of the deal.
- What portion of your number you are willing to risk in the form of an earn-out – if any.
Getting clear on what you’re prepared to risk is important because earn-outs come in all shapes and sizes.
For example, a buyer may offer 90% cash upfront with a six-month transition earn-out and the remaining 10% coming after those six months.
Alternately, the buyer might split the sale price 60/40 over a five-year period during which you must agree to stay with the company and deliver against your forecasts.
Keep it simple and maintain control
Some buyers attempt to construct earn-out acquisitions based on a complicated matrix of goals that covers earnings, customer retention, software features, and a myriad of other variables.
Avoid this at all costs.
Ideally, there should be one or two simple variables you’re held to. The more variables between you and the money you’re owed, the less likely you are to ever see it.
And as far as possible you want complete control over these variables. The last thing you want is for the new owner to be in charge of the marketing spend or some other element that might take control out of your hands at some point in the future.
Get legal counsel
Pay for good advice here and it will save you a fortune.
Always enter into negotiations armed with legal counsel and financial advisors specializing in mergers and acquisitions.
From personal experience, I can tell you that a few things to make sure you keep in your agreement are:
- Keep your key people on board. If there are key players integral to your business’s growth and success, make sure that you come up with deals to lock them in too.
- Keep the length of your agreement as short as possible. It sounds obvious, but you’re likely selling because you’re burned-out, so performing at peak for the next three-to-five years is going to be a tough ask. Try to minimize the term of your earn-out contract.
- Ensure the right incentives are in place. If you’ve taken a chunk of your pay-out off the table, it’s hard to stay motivated to achieve future targets. Make sure the earn-out percentage is attractive enough to keep you motivated through the inevitable ups-and-downs.
- A time delay on the earn-out period. Adding a new product to an existing organization takes time: you’ll need to educate your sales and marketing teams and put compensation plans in place. So, give yourself a few months to embed your product and team into the new organization.
Give yourself a fighting chance
Last but far from least: remember you are likely dealing with an experienced team. They’ve been around the block, and what might seem like a good deal to you now can come back and bite you in the ass.
A seasoned buyer is going to use your overconfidence to their advantage.
One horror story I heard involved a crafty acquirer on a corporate team essentially tricking the seller into an earn-out that they were never going to realize.
The seller had naively pumped up their company’s forecast and the acquirer's deal maker used it to handcuff them into a “sweet” earn-out.
If the seller hit the numbers they’d projected, they would have walked away with a substantial sum.
But because the owner had exaggerated their forecast, that was an impossible target – and the buyer knew it.
The seller couldn’t change their tune about the numbers they’d forecasted without jeopardizing the whole deal, so they accepted the earn-out – then never saw the majority of that money.
Whatever you do, don’t make a similar mistake when you’re negotiating your own earn-out acquisition.
How to avoid an earn-out altogether
An earn-out is a great deal for a buyer… but rarely so good for the seller.
When you and a potential buyer don’t see eye-to-eye on how much your business is worth it’s usually because you don’t agree on the future value baked into your current business.
It’s only natural for you to place a high value on your own business given the sleepless nights that no doubt went into building it.
But put yourself in the shoes of your buyer’s accountants. It’s their job to dissuade their boss from investing in your business unless they have concrete evidence of the future value it’s going to realize.
If there’s no concrete evidence that that’s the case they’ll protect the buyer’s interests by walking away or suggesting an earn-out.
An effective way of avoiding an earn-out altogether is therefore to have audited financials and budgets in place for at least the last three years.
This will not only demonstrate your business’s objective value but also your ability to accurately forecast performance.
What better evidence of that than a track record of detailed annual budgets that show actual revenues and expenses that closely mirror your budget?
On top of this, solid projections for your business’s success in the coming three-to-five years can put you in a position to avoid an earn-out and get paid upfront for your business.
If your business has a track record of performing or exceeding forecasts in the past, this will add to your negotiating power.
- Having a strong leadership team in place that’s capable of running the business without you.
- Your revenues are locked in through long-term contracts which last at least as long as the duration of your financial projections.
- Your business model is based on reliable recurring revenue streams (such as revenue from annual maintenance contracts, recurring retainer fees, or annual licensing and subscription fees)
I’d strongly advise any entrepreneur to avoid an earn-out acquisition.
Spending the next three years using the Core Four to transform your business into a valuable asset you can sell at a premium will net you a far bigger profit than working as a buyer’s employee to try and trigger earn-out payments you’re probably never going to see.
However, if an earn-out deal ticks the boxes I covered in this article and the timing is right, it might make sense for you.
Just be sure you explore all your options before signing on the dotted line of an earn-out acquisition.
Subscribe to The Freedom Experience podcast for more advice on how to build a valuable business and navigate your exit strategy.
And if you’d like help building a business that you can sell for a serious upfront sum rather than having to settle for an earn-out deal, find out how you can work with me.
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