At NAVIX, we know that the term “earn-out” sends a shiver down the spine of business owners. And for good reason. Business owners seeking to sell their business at exit overwhelmingly prefer all-cash deals. Owners know that any portion of the purchase price held back at closing is at risk—you might never see those dollars. Despite owners’ overwhelming preference, most deals are not 100% cash transactions, but instead include any number of mechanisms that pay additional dollars to the seller after closing only upon achieving certain results. One of the most common mechanisms is an earn-out. Here’s why owners seek to avoid earn-outs, and how to avoid getting burned by them if part of your deal.
First, a quick explanation of earn-outs. An earn-out is a provision defining how a selling owner may receive additional payments after closing, contingent upon certain results such as stipulated financial performance or milestones. Earn-outs are used to bridge valuation gaps between the seller and buyer. In essence, with an earn-out the buyer is saying to the seller, “We will pay you more for your company later, if you actually go out and achieve ____________ .”
Here’s an example: You believe your company is worth $15 million, in part because you believe the company will continue to grow 25% per year like it has the last few years. Your buyer is not convinced that the growth rate is sustainable and is only willing to pay $10 million at closing. To bridge the gap, your buyer agrees to an earn-out that may pay you up to an additional $5 million after closing if the company sustains the 25% (or better) growth rate over the next several years.
Earn-outs can be useful in bridging value gaps, and some deals might never be closed without incorporating an earn-out into the agreement. However, an earn-out often trades one problem (i.e. the buyer and seller do not agree on price) for another set of problems:
Owners seeking to one day sell the company at exit should take two steps to avoid getting burned by earn-outs. First, build a company that is so attractive to potential buyers that they will offer all-cash terms. Earn-outs at their core are a mechanism for buyers to limit risk: risk that the company will not perform as desired after sale, risk that existing customers will leave or decrease their volume, risk that top employees will flee, etc. Building a business that sells for all-cash terms involves more than just growing revenues and profits. To avoid earn-outs altogether, you must hire and align a quality leadership team, eliminate your involvement in routine sales and operations, achieve a strong track record of growth, reduce customer concentration, and have effective financial systems and processes. Building a business strong in these areas reduces buyers’ risk to the point that buyers do not see any need for an earn-out.
The second step to avoid getting burned by an earn-out is to hire and work with an experienced exit advisory team. Your accountant, lawyer, investment banker, and exit planner must have extensive experience with situations like yours and be qualified to give you sound advice. Your investment banker and lawyer in particular will be your A-team in negotiating the deal terms, especially any earn-out, and protecting your interests. Do not use general purpose advisors when selling your company. You carry the risk that any fees that you might save will be paid back multiple times over in future costs and losses.
At NAVIX, our clients are prepared to potentially sell their business for all-cash deals and have advisory teams qualified to help avoid the fallout caused by an ill-negotiated earn-out. To learn more about how to prepare your company to sell for 100% cash, contact us to schedule a complimentary, confidential consultation.
To discuss your unique business, and how to plan for and achieve a successful exit, Call 772-210-4499 or email Tim to schedule a confidential, complimentary consultation.