What Is An Earn-Out?
An earn-out is a contingent payout, which essentially involves shifting some of the purchase price to be paid in the future on the realization of future earnings or some other benchmark of success that the parties agree to. So, in this case, the business owner needs to be willing to delay some or most of the agreed purchase price and be aware they might never see it if the business performs poorly in the future under new ownership.
Earn-outs are much more widely used in the M&A (Mergers & Acquisitions) arena, when multimillion-dollar companies are being bought and sold. We typically don’t see earn-outs very often in our world of small to mid-size business sales, mostly because they can be a complicated beast, and require the earn-out to be highly thought out, with each detail accounted for. Additionally, these agreements can get quite expensive for attorneys to draft. Of course, a buyer and seller of a small business can negotiate and agree on the earn-out between them without professional aid, but we would always advise both parties to seek legal assistance with this.
Earn-Outs Typically Favor The Buyer
We don’t see earn-outs too much in the arena of small business sales, because they are typically very one-sided and heavily favor the buyer, as opposed to seller financed deals, where both parties benefit mutually. The buyer normally puts down a sizable down payment (30-50%), and then the rest of the agreed upon purchase price is paid out to the seller based on the future performance of the business. So, in the case of an earn out, the seller assumes most of the risk by transferring their business and business assets to the buyer, and then hopes that the buyer either maintains or improves the performance of the business. The seller needs to have great faith in the buyer, that they are capable of doing this. Furthermore, the seller will need to have some level of trust in the record-keeping of the buyer, to ensure that they hopefully do get paid out as agreed.
Earn-Outs Are Complicated
Another main reason that earn-outs are less common with small to mid-size business sales is that they are extremely complex to structure, expensive to have attorneys draw up the details of the agreement, and time-consuming to track, report, and verify post-closing. All of the parties need to have a very clear understanding what is going to happen and how the earn-out will work. Normally it is recommended that earn-outs are based on gross revenue or sales figures, not owner benefit or profit, because buyers could mis-manage expenses, sometimes to their advantage. The process for documenting the revenue needs to be identified, the seller will then need to be able to see and verify record keeping, etc. It can become quite a mess if not done right, and both buyer and seller need to be aware of the extra time, effort, and cost associated with the post-closing activities in an earn-out situation. This will go on for years, so it needs to be a process that all parties are comfortable with and are ready to take on.
In What Scenario Would We Suggest An Earn-Out?
There are certain extreme cases where an earn-out might be the best way to go or really the only way to go. Honestly, we suggest that an earn-out be a last resort for a seller to accept. The truth is, if a business is showing solid owner benefit and is a good saleable business, a seller probably won’t consider an earn-out in today’s “seller’s market.” Maybe during times when buyers were harder to come by or if the business had been on the market for multiple years with no interested buyers, did sellers need to take an offer with an earn-out seriously. However, in today’s market, if the business is attractive with consistent financials, they will get a qualified buyer who will pay cash, get an SBA loan, or who will want to utilize seller or owner financing. All of those options are far better to a seller than an earn out.
In the case of a more shaky business listing, say it’s ‘owner-to-prove’ and they don’t have tax returns or profit and loss statements that they can provide to the buyer as verification of the business’ numbers (normally in a cash-based business), then because more risk is on the buyer without having solid “proof” of the business’s historical performance, an earn-out might be appropriate. An earn-out might also work if the business is relatively new and has no real earning history. In that case as well, the buyer is taking more of a risk buying this business, and then an earn-out would share some of that risk with the seller.
Get Professional Advice
In general, we don’t encourage earn-outs, just due to the typically one-sided risk to the seller, the complexity of structure and how perfectly detailed they need to be, the extra cost associated with creating and verifying them, and the years of labor post-closing to keep records, report the numbers to the seller, and for the seller to verify all the numbers. It just makes a business sale transaction more complicated than it needs to be. Multimillion-dollar mergers and acquisitions are used to the process and they have the right people, processes, and procedures to ensure that everything gets carried out as it should. Small businesses just don’t have that bandwidth, and the seller is often retiring or wants to move forward with their next chapter in life, not stay tied to this business in an active way for years to come.
Of course, our opinions are based solely and purely on our experience in business sales and should never be considered legal advice. If you have questions about earn-outs, we are happy to share our opinion, but ultimately, we will all direct buyers and sellers to their attorney and/or CPA to assist with any earn-out situation.