Earn-Out Agreements in the Current Merger and Acquisition Environment

In the spirit of March madness (another chance to redeem my bracket flops)

“It’s not what you tell your players that counts; it’s what they hear”
Red Auerbach

Sellers and buyers of privately owned businesses are hearing the term earn-outs a lot more frequently. And, as transaction brokers and advisors, we’re finding that a substantial number of our transactions now include various earn-out provisions.  With that in mind, we thought it might be helpful to provide an overview of what an earn-out is and how it’s used.  Some of the information that follows was presented by Mark Schweighofer, of Stein Sperling Bennett DeJong Driscoll PC at a workshop I recently attended.

Introduction

What is an earn-out – it’s a technique to help structure a deal, using “seller financing” when there is a difference between what the seller wants and what the buyer has offered, i e the price “gap”.
When is it used – its used when there is a difference of opinion which often takes the form of concerns about the expected growth and future financial performance of a business “post-closing”.

Earn-outs often put the buyer and the seller in the same shoes.  IE they both have incentive to see a successful transition and good financial results after the sale.

Earn-out Contingencies – the final purchase price for a deal that has an earn-out component is not known at time of sale; it is “contingent” on some future event(s) as defined by the earn-out agreement.  Examples of earn-out contingencies are:

a. meeting specified, agreed upon financial targets (gross revenue, gross profit, EBITDA etc),
b. customer retention,
c. contract renewals.The final purchase agreement will include the formulas used to determine when the terms and conditions of the earn-out are satisfied and the seller gets paid.

Final Purchase Price Determination – the final purchase price agreement will include the language regarding when the final purchase price is going to be determined.  The final price can be:

a. Stated at a maximum price,
b. Determined within a defined period,
c. No maximum price and no defined period

Interest on seller financing – remember that earn-outs are really a form of seller financing during the earn-out period.  Therefore, interest must be separately stated; if not, a portion of the deferred payment could be reclassified by the IRS as interest

At least for the foreseeable future, earn-outs are a part of almost every transaction.  Understand and prepare to agree to a reasonable earn-out in your upcoming sale.

Click to see our related post on Taxation of Earn-outs.

Ed Davis, CPA, CVA
Harvest Business Advisors
Business Brokerage, Business Valuation, Transaction Planning
410-507-5441
www.harvestbusiness.com