Earn-outs: inside and out

Agreements regarding the sale of a business can be structured in many ways, typically involving cash, stock, financing and earn-outs in varying degrees.

From the perspective of the seller, and any adviser acting on their behalf, the key to any structure is to ensure it protects the business owner and their financial legacy.

Despite their obvious appeal, very few 100% cash-on-completion deals are agreed. This has particularly been the case over the last few years when buyers have gone to great lengths to reduce risk. As a consequence, earn-out structures have become increasingly prevalent, given they can allow sellers to achieve optimal deal value, whilst at the same time reducing buyers’ exposure to risk.

Investopedia defines an earn-out as “a contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals.”

The key to agreeing a positive earn-out for a seller is the achievability of the performance related goals attached to it. These will typically be set against forecasted financial figures, and, as such, it is essential for the business owner to be completely honest about the potential growth of their company.

Whilst an earn-out can be a positive way of bridging the gap between sellers’ and buyers’ respective view of value, without the certainty of key performance indicators being met, it is also important for sellers to realise they must commit the same, if not more, time and effort post-agreement to ensure performance indicators are achieved.

In many instances, when embarking upon the sale process, sellers expect a clean break following completion and it can be difficult to find the inner drive once more to push the business forward. For this reason it is vital the seller is fully aware of this possibility from the outset and willing to work on to maintain (or exceed) the company’s current performance levels.

For those circumstances where continuing within the business is not an option, business owners need to prepare themselves for the possibility of not obtaining maximum value upon sale.

However, owners willing to remain in-situ for a period, and possessing the drive to achieve the agreed goals, can feasibly achieve sums exceeding the current value of the business - a value which matches the Company’s true potential.

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