When selling their business, owners seek maximum return on their investment. Sometimes, however, there may be different expectations between the buyer and seller as to the value of the business. For example, it may be difficult to value a start-up or a company operating in a volatile market.
This is where an earn-out arrangement can be a valuable tool.
So, What is an Earn-Out?
An earn-out is a mechanism where the price depends on performance after the sale. It is a type of purchase agreement allowing the seller to receive a portion of the price as a payment based on the performance of the business post-acquisition. Performance is typically measured against pre-determined metrics e.g. profit, revenue or some other agreed milestones over a defined period. Typically seen in businesses with high growth potential but earn-outs can be useful during times of economic uncertainty where future performance is unclear.
How Does it Work?
The buyer agrees to pay the seller a certain amount upfront. In addition to this base price, the seller stands to earn further payments contingent upon the business achieving set targets. These targets are negotiated and outlined in the sale-purchase agreement.
The earn-out period tends to range from one to three years, although it varies depending on the nature of the business and industry. During this time, the seller might remain involved in the business, possibly with a place on the Board, to ensure a smooth transition and help achieve agreed targets.
What are the Benefits for Sellers?
- Maximising value: Earn-outs offer sellers the opportunity to realise the full potential value of their business. With a portion of the purchase price linked to future performance, sellers can command a higher overall price.
- Mitigating risk: Sellers can mitigate the risk associated with uncertain future performance by sharing it with the buyer. If the business fails to meet the agreed targets, the seller may still receive the upfront payment while the buyer bears the risk of underperformance.
- Aligned interests: Earn-outs align the interests of both parties. The seller has a vested interest in ensuring the business’s success post-acquisition, which helps foster collaboration and cooperation between buyer and seller during the transition.
What are the Benefits for Buyers?
- Reduced upfront costs: Buyers can conserve financial resources by paying a portion of the purchase price upfront and deferring the rest until the business achieves certain milestones.
- Performance-based: By linking a portion of the purchase price to future performance, buyers can align their payment with the actual value generated.
- Incentivising the seller: A seller remaining involved in the business during the earn-out period can provide valuable insights and expertise for the buyer
Any Other Considerations?
- Negotiation: Careful negotiation is needed to agree on terms that ensure fairness for both parties. Sellers will want to see achievable targets, while buyers need to assess the risks and rewards. It is important that the agreed terms are clearly drafted to ensure the seller understands what is expected of them and has security in their position, whilst the buyer will want the ability to remove the seller from the business should they underperform.
- Measurement: Defining and agreeing clear, measurable performance metrics and identifying how performance will be tracked is crucial to avoid disputes.
- Integration: Buyers need to consider how to integrate the acquired business into existing operations while respecting the role of the seller during the earn-out period. Collaboration and clear communication will help mitigate potential conflicts.
Deciding if an earn-out is right for your business sale or acquisition will vary depending on the specific circumstances of the transaction. An earn-out is a valuable tool, benefiting both buyer and seller in certain circumstances, but may not be worth considering if, for example, the buyer intends to transform a business and merge into their own (whereby the seller’s performance targets would be hard to measure).
Earn-outs can be considered as part of an overall strategy – whether business sale or acquisition planning – providing options that assist the transaction process. As with any key business decision, discussing your options as early as possible and seeking expert, professional advice is crucial.
Altius Corporate Finance is part of the Altius Group. For those considering the next steps, talk to our advisers about opportunities available across a wide range of sectors throughout the UK that ACF has to offer.
