The Advantages and Disadvantages of an Earn-Out Agreement for Sellers

As the owner and potential seller of a business, it’s only natural that you may value the company at a greater amount than a prospective buyer. So what can you do when you and a potential buyer are at odds over the fair purchase price of the business? One option is to utilize an “earn-out” agreement.

An earn-out agreement is a mechanism in a transaction whereby a portion of the purchase price is contingent (and calculated) based on the performance of the business after closing. It is intended to bridge the gap between an optimistic seller and a skeptical or cash strapped buyer by allowing the buyer to close at a lower up front price and providing the seller with financial rewards if the business achieves or surpasses certain performance metrics (e.g., revenue, customers, etc.).

Advantages

From the seller’s perspective, there are a number of key advantages to utilizing an earn-out agreement. First and foremost is the prospect of making more money off of your business after you have sold it. Earn-outs allow business owners who sell their business to continue benefiting from their hard work to establish the business as a profitable enterprise.

Earn-outs also give a seller leverage to close a deal with a buyer who may be hesitant to trust the seller’s future forecasts, may have valued the business using a different method, or simply does not have the upfront capital to purchase the business at the price the seller is seeking. Finally, an earn-out can defer some of the tax burden that arises from the sale of the business, since the seller will not have to pay taxes on the earn-out profits until they are actually earned.

Disadvantages

Earn-outs are complex and require careful consideration (e.g., aligning of incentives between the parties, use of the proper metrics or milestones, etc.) and they require careful drafting.

When using an earn-out, it’s important to understand the metrics or milestones that will be used in the earn-out and make sure that there are appropriate controls and incentives to produce mutually beneficial behavior. For example, using “profit” as the metric or milestone can be a big mistake because the buyer of the business (as the operator post-closing) can “control” the profit through the business expenses.  

In addition, earn-out agreements require careful drafting, including carefully drafting definitions and covenants. For example, if an earn-out is based on top line revenue for a company and the buyer (after closing) adds (through his/her own execution and implementation) a new product or service line that generates significant revenue, should that revenue count towards the achievement of the milestone? As the seller, you may want to make sure that the buyer (after closing) is exerting some minimum level of marketing or effort promoting the drivers that will help achieve the milestones. Likewise, as the seller, you may want to assure that the buyer doesn’t materially change some aspects of the business that could result in a lesser likelihood of achieving the milestones.  

If you are considering selling your business, and especially if you are considering including an earn-out agreement in the transaction, please contact the Doida Law Group right away to set up a consultation and allow us to analyze the potential advantages and disadvantages of utilizing such an agreement.

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