When Do Earn-outs Really Work?

Here’s a universal truth about earn-outs: buyers love them and sellers hate them.   From a buyers point of view, what could be better?  We are deferring a portion of the purchase price and transferring risk back onto the seller.  From the seller’s point of view…. what a load of horse-hockey!   The opposing views are understandable: the two parties have a problem of perception and an asymmetry of knowledge.   But nonetheless, an earn-out is a provision that can occasionally help close the value gap.  Here’s 3 rules of thumb to help implement effectively:

Do’s

1. Use to pay for growth.  A classic example of where earn-outs work is in companies experiencing on-going growth.  We’ll often pricing the business based on the growth curve, but structure such a portion of the deal is based on current earnings and the earn-out is based on future earnings growth over historical.  Now here is the important part: this works for a grow-ING business- i.e. one that has consistently delivered growth.  The hang up is often when a seller wants to be compensated for future growth but has been flat in recent years.  Logic suggests that growth in that case is due to the efforts of the buyer- why would the buyer effectively pay extra for the fruits of their own labors?
2. Mitigate obvious risks.    All business has problems.  And some of the problems are more likely to rear their ugly head during an ownership transfer.  A prime example is a company with revenue concentration issue.  Say for instance that a $20M manufacturing business has one long term client relationship generating $10M of revenue.  Ouch.  The seller is probably comfortable based on this long term experience.  A buyer?  Not so much.  There’s really only three possible solutions here: adjust purchase price downward to account for risk, structure an earn-out to account for the potential loss of the client, or the seller can wait until they have developed a more balanced client portfolio.    Assuming the seller would rather not take less money, the choice becomes binary: an earn-out or wait to fix the problem.

Don’t

1.  Use to cover financing gap.  If the buyer simply cannot get access to enough capital to finance the deal, an earn-out is likely not the best solution.  Doing so is mixing metaphors, so to speak.  An earn out is a device designed to mitigate risk.  If access to capital is the issue, then a promissory note is a better device.  Using a promissory note, the seller closes the value gap without bearing both the execution risk and the payment risk.
2. Get an SBA Loan.  This is an easy one.  Thinking of getting an SBA 7(a) loan?  Great idea, and great way to access capital from small and otherwise “unbankable” deals.  I have no clue why, but the 7(a) program does not allow for earn-outs.  You can (and often will) include a seller note, but an earn-out is a hard no.

Bottom line, earn-outs can be a great tool to help structure a transaction.  Parties like to mis-use them, though,  and this results problems.  My experience is that when earn-outs are used inappropriately the result is a protracted negotiation that consumes a huge amount of time and resources… but doesn’t close.  Working with an experienced M&A advisor or investment banker can often help sidestep these problems by working from a more realistic deal structure to begin with.