When you are ready to exit your business, there are several ways to structure a deal. Today, a deal will often involve incremental payments, clauses and other conditions rather than just a lump sum. Our M&A advisors recommend to lay out any deal as simply as possible, so both acquiring and exiting parties understand the terms of the agreement. This point is amplified when an earn-out is involved.
An earn-out can help bridge a gap in valuation between a buyer and seller. Instead of a single payment, the buyer will initially pay a percentage of the agreed price, with the remaining value paid once certain obligations are realized post-acquisition.
For example, say a company is valued at $10 million, but because of risk associated with the future projections of the company, a prospective buyer wants to pay just $5 million. An earn-out could close this gulf – the buyer pays the initial $5 million, with the remaining price paid contingent upon the company reaching agreed to levels of revenue and/or earnings (or other metrics) over a specific time frame.
Compromise is invaluable in closing a deal, especially if it helps limit the risks a buyer could associate with a purchase. As such, a payment model that is applied post-acquisition can help reassure buyers about your company growth, and secure you a better overall return on investment. But, there are risks associated with earn-out agreements.
“Earnouts can be wonderful deal provisions, but the key is that they must [be] kept simple and be based upon easily measurable metrics such as revenues or customer count, or profitability as long as there is a pre-determined formula to calculate it.”
This four-part series will provide an in-depth introduction into the potential pitfalls of earn-out agreements. We hope this provides the guidance you need to pursue these deal structures with confidence when you choose to exit your company. In this first piece, we consider a valuable starting point – what are the conditions of your earn-out.
Now, this feels like the logical first step of these negotiations: what conditions will you, the company owner, need your business to fulfil to achieve the biggest return? This will be the foundation of your earn-out provisions, so it is essential that it is approached with due care and attention. Our dealmakers, having handled many of these agreements in the past, champion this piece of advice:
They say too many cooks spoil the broth, and too many conditions spoil your chances of a fair earn-out agreement. Therefore, it is important you have a clear understanding of the terms you will need to fulfil to guarantee the full price for your business. Each condition you add as part of the arrangement makes it that much more difficult to hold up your end of the bargain.
So, what metrics do you choose? The 21st National M&A Institute of the American Bar Association (ABA) offered numerous examples of measurement standards in earn-out agreements, including but not limited to:
It is important to remember that not all deals are based on purely financial measurements – you might be expected to execute a contract, or complete the development of an important product. It is about choosing the right conditions for your financial future. Our advisors at Generational Equity recommend no more than one or two – the simpler the better so all parties recognize what the end goal is.
But it is not just how many you choose, but which ones you choose. This choice is about guaranteeing fairness, which can be a challenge on both sides. For instance, revenue growth is an easily measurable indicator, but it could be hiding holes in a business’ bottom line. Conversely, net income is a more accurate assessment of profitability, but could be manipulated by unnecessary expenses once the deal has been concluded. It is essential to negotiate the best compromise for all parties, and establish an impartial referee to ensure fairness, whether the business reaches its expectations or not.
Our final recommendation in this part is establishing tiers in your deal structure. While we want to keep things simple, this will be key in ensuring your earn-out isn’t all-or-nothing. Say we take the earlier example: if the company’s revenue doubles post-sale, you receive the full $5 million expected. But, if it grow only grows by 50%, you arrange for this to be worth $2 million rather than nothing. This way, you are safeguarding against unforeseen circumstances and other factors that could stop you reaching expectations.
We hope you enjoyed this first in-depth exploration into earn-out agreements and how it is crucial to establish how they will be measured. In our next piece, we will go into greater detail of the importance of determining the true value of your company before entering any arrangement. Alternatively, you could consider attending one of our executive conferences. These offer you a complete breakdown of the M&A process, including information on earn-outs, and provide useful strategies to prepare for a successful exit.
For more information, you can reach us on our dedicated contact page.
The professionals at Generational Equity then helped develop a roadmap for enhancing the value of the firm and an evaluation report. This was completed by June 14, 2021. We then developed the Confidential Information Memorandum and put Taylor Studios, Inc. on the market by July.Betty L. Brennan, President, Taylor Studios
Generational Equity’s professional staff helped me every step of the way. Their network and professionals are the only reason I sold my company this quickly. For me this is a once in a lifetime sale and I was unfamiliar with the process. I was able to lean on them with questions and concerns.
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T.D., thank you so much! You are a great leader! I love how you are using your gifts and talents to better others. You are clearly a GREAT COACH! This 3 day session undoubtedly changed the future of our business, and very well may have been the sole catalyst to save my company, my health and my marriage! A genuine “thank you” from the bottom of my heart.Bryan D. Horn, Owner, Over Under Clothing
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Generational Equity educated and informed us – so that we could be on the upside of a good decision (to sell).Bil MacLeslie, CEO, ipHouse
The process was much more involved than I expected and your help, experience and advice was a big factor in making the negotiations go as smoothly as possible.Terry D. Wickman, President, Keytroller
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We thank you Eric and Generational Equity making our dream come true.Larry Moore, Owner, A Company Portable Restrooms
We had the pleasure of working with Mr. Ahmad Behjati Managing Director, M&A, for Generational Equity during our acquisition of Papa's Dodge in late 2021. Generational Equity and Mr. Behjati represented and marketed Papa’s Dodge. As our primary contact, Mr. Behjati was professional in every facet of this acquisition process, conveying valuable advice most times and assisting us in every step of the process.Rick Greene of Dobbs Equity Partners LLC
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I wanted to take this opportunity to thank you for all that you have done for us. Not only did you take care of all the aspects of the sale but took extra care to make sure we knew what it looked like every step of the way. I will definitely recommend your company to anyone that is in a position to or looking to exit their business.Shane and Johanna Kline, Owners of Vision Upfitters
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After attending a conference with GE, I decided that the value they bring would be worth the expense and as soon as I started working with them, I realized that was the right decision. When we started to get LOIs, Fred Zweifel took the lead on the communication and supported negotiations throughout the process, which got tricky as we moved forward. I learned that it can be common for companies to make a great offer then work to erode that price with their discoveries, but Fred and the GE team kept that from happening.Caroline Connelly, CEO, OptoTest
The help you provided us during each step of this process made us feel very comfortable and confident we were selecting the right approach to transition our Company.Andy Graham, Vice President, Modern Heating & Plumbing
I decided to attend the conference and hopefully receive some guidance on how to structure an exit plan of my business. Upon arriving at the conference, I was so impressed with the presentation given by Generational Equity that I set a future appointment that week to discuss the possibility of selling my business with their Senior Managing Director David Robinson.JoAnn Ellis, Owner of Fondren 5 Star Kennels
Greetings Mike. Thank you for the captivating and compelling presentation you made at the Phoenix presentation last week. Over many years in business yours was the most informative and well-presented presentation, on any subject, that I have ever attended! Your energy and enthusiasm combined with your concise and captivating support of your positions with easily understood examples and data was compelling.Pete L.
I would like to thank you and your firm, Generational Equity, for being our valued advisors in our journey.Bil MacLeslie, CEO, ipHouse
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Thank you again for all your guidance and support. Any company will achieve what they intend, if they have you on their team!Rick Nowak, President/CEO, Kurz Electric Solutions, Inc.
We were represented by Michael Goss with Generational. The due diligence was grueling and exhausting, but Michael propped us up and kept us motivated throughout the process. Debi and I continued to ask each other how we could possibly make it through this process without the assistance of Michael. Michael's professionalism and knowledge is absolutely amazing, and we are so blessed to have had him by our side as we made our future dreams come true.Bob and Debi Lee, Owners of BL Technology, Inc and BL Tl Services, LLC
We are very happy with the end result, and are very happy to be able to move forward with all of our future growth plans.Rick Nowak, President/CEO, Kurz Electric Solutions, Inc.
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