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:
- 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?
- 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.
- 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.
- 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.