Earn-outs are very common these days in transactions where an owner is selling a business. I’m working on a number of transactions right now that have an earn-out component to them.
Before 2008, most transactions involved the seller getting most if not all of the purchase price on closing. If there was a deferred payment, it would be for a set amount and on the basis of a holdback for fairly short period of time – perhaps three to six months. Once the 2008/2009 recession impacted the market, business owners found that buyers were asking for earn-outs as part of the purchase price. Why the change in direction?
An earn-out is simply the method by which a purchaser seeks to reduce the risk it is taking on when purchasing a business. Of course, when a purchaser reduces its risk, the effect is that the seller takes on more risk. So, from the seller’s perspective, the earn-out is not something a seller should agree to right away. The earn-out works to reduce risk to the purchaser by allowing the purchaser to pay a lower amount on closing and then “see how it goes” in order to determine whether to pay the seller more money. Effectively, the purchaser is saying to the seller that the business isn’t really worth what the seller believes it is worth, but the purchaser is willing to pay more if things turn out well.
From the seller’s perspective, the problem with an earn-out provision is that payment of additional sales proceeds will depend on how the purchaser runs the business. If the business succeeds, then the seller gets more money, but if it doesn’t succeed, the seller gets no additional payments. Therefore, the ability of the seller to get full payment of the purchase price is dependent on the purchaser’s ability to run the business. Another difficulty with the earn-out provision is that it must be drafted clearly and concisely in order to avoid disputes later. If clear language and well defined parameters are not used, there is the potential for manipulation of numbers so as to ensure the earn out amount is not achieved. There have been many lawsuits surrounding the interpretation of earn-out provisions.
There is much more to earn-outs than I can deal with here. The key is for you to obtain the advice of an experienced lawyer and accountant/tax advisor so that the best result is obtained for you.