Using an earn-out agreement in a business sale
Simply put, an earn-out agreement is a contractual prearrangement in an acquisition which mandates that the seller receives additional compensation if the business reaches its discussed financial goals over a specific time frame following the sale.
In some instances, this purchase arrangement can be a separate arrangement within a merger or acquisition’s documentation.
It may appear that the earn-out is mainly set to benefit the vendor as it ensures the maximum possible return on a sale, but if arranged appropriately in certain circumstances, there is no reason why it cannot be a win-win situation for both the buyer and the seller.
In its most basic structure, an earn-out calculates the company’s current and potential purchase value using predicted future revenue figures. This determines the value of the sale and can prove beneficial to both the buyer and seller as it cements a business deal. Having an earn-out ensures that a buyer does not have to front all the cash at the point of sale, but instead can leverage the business to pay for some of its own purchase costs.
Who did it right
Take, for example, Vianet Group’s acquisition of Vendman Systems with a successful earn-out in place. The £4.2 million sale, payable in cash, resulted in a sizeable earn-out of £2.25 million based on targets achieved in the first two years. The remaining £2 million was funded by a bank loan. In due course, the earn-out gave Vianet the financial leeway to make the strategic acquisition, extended the capabilities of both companies, and boosted business growth for all parties involved.
Earn-outs bridge the gap in expectations between the buyer and seller, allowing both parties to be on the same page before entering an agreement for sale. In many instances, an earn-out is the sole reason a sale can even be achieved.
Beyond this, earn-out agreements bring a number of other benefits as well, including alleviating some of the uncertainties surrounding the business’s value, and the benefit of choice a buyer has when it comes to deciding whether or not to keep the seller around after the sale of the company.
From the seller’s perspective, an earn-out affords them the opportunity to realise the best value of the business from the sale, as well as the ability to control the direction of the business after handover. In addition, it opens up the seller to all its options in terms of who exactly to sell to, and at what price.
What are the risks?
However, those in the acquisition market remain cautious of earn-outs due to certain risks. These include:
- The possibility that earn-out calculations will be manipulated by the buyer or seller
- Focusing too much on short-term successes which may impact the company’s long-term goals
- Integration difficulties in the face of having two bosses, as well clashes in business interests and target setting
- The risk of buyers limiting the seller’s control over business operations during the crucial earn-out period
- An unplanned event that threatens the buyer's final payment to the seller
Sellers must remember that if the earn-out does not pan out as planned, only the buyer comes out of the situation as the winner.
As with any deal, it is the responsibility of the involved parties to make a calculated decision as to whether or not an earn-out is worth the risk. Thorough analysis of finances and past performance metrics can assist with alleviating the potential dangers, and can help in forecasting the successes of the business as a whole.
Time is of the essence. Typically, there is a transition period following the sale, during which time the seller is busy integrating processes and systems whilst also navigating the acquiring company’s culture. If the buyer has agreed to monthly sales targets and falls behind in these first few months of integration, it can generate a domino effect that makes catching up almost impossible. In this case, the buyer may never claim the final sales-contingent tranche of payment.
Where it went wrong
A buyer’s ideal scenario is that the seller just misses out on earning targets, i.e. the company hits high sales and profitability but not quite enough to trigger earn-out payments.
Unfortunately, this is precisely what happened to Rod Drury after he sold his first business, AfterMail, to Quest for a reported US$45 million in 2006. In fact, the actual amount he received upon sale was just US$15 million, with the rest promised upon the business reaching specific goals.
Alas, it never happened. AfterMail failed to reach its targets in the first few months after acquisition and was unable to catch up; as a result, Drury did not receive the grand pay-out he was hoping for. However, it wasn’t all doom and gloom for him. Drury later went on to setting up online accounting firm Xero, which is now worth billions.
How to do it right
That said, to avoid a situation like what Drury was in, sellers can mitigate the risks by establishing targets that consider the effects of the post-purchase lag. Earn-outs are already complex transactions with many significant periods of ‘unknown’ for both parties, but when structured and applied appropriately, they can yield positive financial rewards for the seller and give buyers some assurance in that they will avoid overpaying on untested potential.
A prime example of a mutually successful earn-out was the 2012 sale of John Lewis’ advertising agency Adam & Eve to Omnicorn. A five-year agreement was negotiated, and resulted in a three-fold increase to roughly £85 million from the original sale price of £25.2 million. The resulting pay-out was £110 million.
Before it sold, Adam & Eve was making an annual profit of £3 million which made the £25.2 million upfront payment more than eight times the amount. By the end of 2015, the earn-out had risen from £17 million to £50 million, and hit its final figure of £85 million by the end of 2016.
Evidently, the founders were deeply committed to growing the business, as demonstrated by their determination in winning the North American Samsung contract in 2016. As well as the sellers benefiting from the rapidly appreciating earn-outs, this motivation was hugely rewarding to the new owners.
What precautions to take
By no means is incorporating an earn-out agreement into an acquisition deal the simplest or quickest process, but the potential gains can be worth the time and effort. When negotiating the deal, the seller should seek to keep as much control as possible over the assets and the budget, and any major future operations. The contract ought to include provisions to protect the seller’s interests and should penalise the buyer if the agreed conditions are not adhered to. It may also be possible to guarantee a minimum payment for the earn-out.
Both buyer and seller should expect that the other party will insist upon having mechanisms in place to ensure financial transparency over the earn-out period. This should not be objected to as clarity from both parties will prevent later disputes during the earn-out period.
While they are often viewed as a greater benefit to the buyer than the seller, earn-out agreements can protect the interests of all those involved and can, as with Adam & Eve, ensure profitability and success for both camps.
In times of economic uncertainty where bank financing is limited, buying through an earn-out is one of the most popular ways to bring more buyers to the negotiating table, thus increasing the competition and making it more likely that a higher price will be struck.
If the seller has groomed and prepared the company for sale to maximise its value, provided it is inherently profitable and attractive to the market, then efforts should be focused on bringing in multiple offers, specifically cash offers. Any earn-outs must be viewed as bonuses.
With the right advice from professional services and a structured approach to negotiations, earn-out agreements can be a valuable way of progressing a successful sale.
Find a business for sale or if you’re looking for more tips on buying a business, have a look at our other articles on:
- The Due Diligence Process
- Legal essentials when buying a business
- M&A insurance: Are you covered
- How to negotiate the sale of your business
- Top 10 questions to ask a seller before buying a business
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