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 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
Generational Equity educated and informed us – so that we could be on the upside of a good decision (to sell).Bil MacLeslie, CEO, ipHouse
We thank you Eric and Generational Equity making our dream come true.Larry Moore, Owner, A Company Portable Restrooms
Thanks again Phil and feel free to have a future client call me if they would like a referral. You are a true professional!Andy Graham, Vice President, Modern Heating & Plumbing
We are extremely pleased with the way Generational Equity handled the sale of our company. Your associates, Tom and Chris, did an outstanding job of getting us (me) through the process.Michael J Polarek, President, Paragon Packaging
Your wisdom and experience were invaluable to me during this once-in-a-lifetime transaction.Ralph Noblin, President of Noblin & Associates
I quickly recognized that Don was working for Sharpe Mixers above all else, and held our interests above others.Jay Dinnison, Owner of Sharpe Mixers
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.
Dear Chris and Andre, I just wanted to say thanks for all your help. Even though this process was not an easy one, it was comforting to know that I had a capable team standing beside me. You made me feel like we were almost your only client or at least the most important one. Thanks again, and I will recommend your service in the future.Shenille Engelhart, Owner – CLS Technology
Generational Equity’s assistance was invaluable in compiling and marketing our business.Bil MacLeslie, CEO, ipHouse
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
We were happy to see the interest in our company and what we cherished has not just a valuable company but an important company to the communities we served in.Larry Moore, Owner, A Company Portable Restrooms
Bruce and I wanted to take this opportunity to thank Generational Equity for assigning Musa Jagne to our transaction. In Bruce’s words, “Musa did one hell of a job for us!”Karen S. Williams, CFO, BW Manufacturing
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
I must say that I have never worked with a more driven, competent and focused individual as Don Ho.Jay Dinnison, Owner of Sharpe Mixers
I am pleased that I was able to work with Andrew Byrd throughout this experience. From the first meeting we had in Minneapolis I felt that I was in good hands. His knowledge and expertise is second to none. He guided the process consistently throughout. I feel lucky that I was pared with Andrew and could not be happier that I chose Generational Equity to handle this major life event. Thank you Andrew and GenEq for everything!Eric Erlandson, Owner, Action Fastenings, Inc.
I couldn’t have asked for a better team than Michael and Deborah. We couldn’t have done it without them.Robert Evans, President and CEO of Mealtracker Dietary Software
Michael worked tirelessly, He followed every lead meticulously and urgently to make sure nothing was missed.Robert Evans, President and CEO of Mealtracker Dietary Software
I need to say an immense thank you to Don Ho for his stellar work ethic, attention to detail, and tireless effort. Also thank you to the whole crew at GE! Without you, Don could not do such a phenomenal job. We were shooting for closing and funding before the end of 2020, due to the uncertainty of the political landscape and taxes. I am happy to report we closed last week and will be funding tomorrow.Dr. Caty J. Catron PhD, RN, VA-BC – Owner, Vic The Picc, LLC
I wanted to write you a quick letter to express our appreciation and our delight on the outcome of helping us through the process of our recent sale. 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.Terry D. Wickman, President, Keytroller
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.
We knew it would be a difficult task to have someone really understand our business and our market, prior to researching a possible buyer, so it was imperative that we found someone of your caliber, with definite proven experience in this area.Rick Nowak, President/CEO, Kurz Electric Solutions, Inc.
I would like to thank you and your firm, Generational Equity, for being our valued advisors in our journey.Bil MacLeslie, CEO, ipHouse
We will highly recommend Generational Equity and Musa Jagne to any business owner about to embark on the same process.Karen S. Williams, CFO, BW Manufacturing
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.
Tom Staszak is one of the most professional people I have dealt with in my last forty years of business. You’ve got a great group of people and you have built a truly professional organization.Michael J Polarek, President, Paragon Packaging
The information we learn from customers helps us personalize and continually improve your experience. Here are the types of information we gather.
We receive and store any information you enter on our Web site or give us in any other way. We do not sell or rent your personal information to others without your consent. We use the information we collect only for the purposes sending promotional information, enhancing the operation of our site, serving advertisements, for statistical purposes and to administer our systems. We DO NOT use third parties to provide customer service, to serve site content, to serve the advertisements you see on our site, to conduct surveys, to help administer promotional emails, or to administer drawings or contests, but reserve the right to do so in the future without advance notice.
Generational Equity, LLC’s affiliates are all part of one corporate family, they work with one another and may work together to provide services to you. The sharing of your information among affiliates enables Generational Equity to serve you more efficiently and makes it more convenient for you to do business with Generational Group. Generational Equity is permitted by law to share information with its affiliates. All of our affiliates follow similar privacy policies.
For reasons such as improving personalization of our service, we might receive information about you from other sources and add it to our account information.
Generational Group may license the use of its intellectual property including but not limited to its name, likeness, and logo for the use of affiliated offices. Such affiliated offices may not be owned, controlled, managed, supervised or staffed by employees, officers, or agents of Generational Group. Affiliated offices may be independently owned and operated. For more information about a particular office, please contact Generational Group at its office in Dallas, Texas.
This page may contain other proprietary notices and copyright information, the terms of which must be observed and followed.
Information on this web site may contain technical inaccuracies or typographical errors. Information may be changed or updated without notice. Generational Group may also make improvements and/or changes in the products and/or the programs described in this information at any time without notice.
Generational Group does not want to receive confidential or proprietary information from you through our web site. Please note that any information or material sent to Generational Group will be deemed NOT to be confidential. By sending Generational Group any information or material, you grant Generational Group an unrestricted, irrevocable license to use, reproduce, display, perform, modify, transmit and distribute those materials or information, and you also agree that Generational Group is free to use any ideas, concepts, know-how or techniques that you send us for any purpose.
Our computer system protects personal information using advanced firewall technology.
Information Generational Group publishes on the World Wide Web may contain references or cross references to other products, programs and services that are not announced or available in your country. Such references do not imply that Generational Group intends to announce such products, programs or services in your country. Consult a Generational Group representative for information regarding the products, programs and services which may be available to you.
Generational Group makes no representations whatsoever about any other web site which you may access through this one. When you access a non-Generational Group web site, please understand that it is independent from Generational Group, and that Generational Group has no control over the content on that web site. In addition, a link to a non-Generational Group web site does not mean that Generational Group endorses or accepts any responsibility for the content, or the use, of such web site. It is up to you to take precautions to ensure that whatever you select for your use is free of such items as viruses, worms, Trojan horses and other items of a destructive nature.
IN NO EVENT WILL Generational Group BE LIABLE TO ANY PARTY OR ANY DIRECT, INDIRECT, SPECIAL OR OTHER CONSEQUENTIAL DAMAGES FOR ANY USE OF THIS WEBSITE, OR ON ANY OTHER HYPERLINKED WEBSITE, INCLUDING, WITHOUT LIMITATION, ANY LOST PROFITS, BUSINESS INTERRUPTION, LOSS OF PROGRAMS OR OTHER DATA ON YOUR INFORMATION HANDLING SYSTEM OR OTHERWISE, EVEN IF WE ARE EXPRESSLY ADVISED OF THE POSSIBILITY OF SUCH DAMAGES.
Furthermore, all information contained within this website is the property of Generational Group.
Honored to win Investment Banking Firm of the Year 3 years running.
Over 50 awards and counting.
Sign up to receive regular email updates, industry-leading insights and details on complimentary M&A executive conferences in your area from our award-winning team
Success, you have been added to our list.