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What you should know about earn-out business transactions

What is earn-out or earnout, as it is also spelled? You should know this if you want to buy or sell a business. Otherwise, you risk accepting a deal that does not reflect the real value and potential of the business.

Some people think earnout is a form of bonus or seller financing. This is not the case.

It's much more complex and it's important to understand the structure of earnout to avoid misunderstanding between buyer and seller. If the agreement is unclear, disputes and conflicts can arise between the parties. A good agreement, on the other hand, creates security and incentive to grow the business.

This article provides a good overview of what a good earn-out entails when selling a business.

What is earnout

When a business changes ownership, an earnout is sometimes included in the deal. This is also known as a variable purchase price and is a small part of the overall deal that results from the sales process.

Yet variable purchase price is one of the more complex elements that can be challenging to negotiate in a business transaction.

Business Broker has advised on more than 200 business transactions. We therefore have extensive experience in assisting buyers and sellers in entering into earn-out, ensuring that both parties experience a fair and secure transaction.

Business broker at Business Broker, Ulf Steiness, explains:

"In short, an earn-out means that part of the purchase price is paid later than at the time of the actual transfer of the business. The remainder of the purchase price is made dependent on certain parameters agreed upon by the buyer and seller."

When is earn-out ?

Earnout is a tool to bridge the gap between buyer concerns and positive seller expectations.

However, Ulf Steiness emphasizes that this is not relevant in all transactions. He estimates that this applies to approximately one quarter of the cases in which Business Broker advisor.

An example of a concrete agreement

An example of a transaction where it is relevant to agree on earn-out:

A company is valued at DKK 50 million. The buyer estimates that 20 percent of the company's future earnings are tied to the fact that

a core product continues to grow
the development of recent years can be maintained
or that the company's employees and customers are loyal after the ownership change.

This can cause uncertainty for the buyer.

"The parties can therefore enter into an earn-out , whereby 20 percent of the purchase price, i.e. DKK 10 million, is payable at a later date. One condition may be that selected key figures are maintained by the company for an agreed period," explains Ulf Steiness.

The buyer and seller often agree on a top and bottom limit for an earn-out. In the example, the bottom limit could be DKK 8 million and the top limit could be DKK 12 million.

This way, the seller receives extra payment if the performance exceeds the target and less if the estimate does not live up to expectations. If the salesperson stays with the company for some time after the sale, it will be an incentive to work as dedicated as before the sale.

When is an earn-out interesting for the seller?

Earn-out often Earn-out up by buyers as a way to get some security. On the other hand, this can be a concern for sellers, who don't have the same chance to influence how performance targets are met after the change of ownership.

To provide a financial upside for the seller, the deal must therefore have the right conditions, emphasizes Ulf Steiness.

"When we advise sellers, we identify the measurable parameters that sellers can influence in the 1-3 years following the change of ownership. Business Broker these conditions as protective mechanisms in the agreement," he explains.

The agreement ensures that the seller receives a fair calculation of earn-out if, after closing, the buyer chooses to reorganize the company or incur new extraordinary costs that reduce earnings during earn-out .

“A good earn-out must be structured so that the buyer and seller have a shared interest in getting the most out of the deal,” says business broker Ulf Steiness.

A good earn-out is tailor-made

Every business is unique. Therefore, every transaction agreement between buyer and seller will also be unique.

For the same reason, there is no standard template – only tailor-made solutions for earn-out. The conditions are far from always being linked to earnings. They can also be linked to turnover, growth rates, or agencies. It will be individual from case to case.

Common measurement points are:

Total revenue
Revenue to specific customers
Turnover of selected products
Contribution margin
Earnings before interest, taxes, depreciation and amortization = EBITDA

It is also possible to agree on some form of royalty for a longer period based on revenue. This is attractive if the product has a strong brand.

Why the buyer may not want an earnout after all

Although it is typically the buyer who brings the earnout proposal to the negotiating table, it is not uncommon for the buyer to want something else during the negotiations.

In practice, Ulf Steiness observes that in some cases where the buyer brings earn-out the negotiation, it ends up being replaced by an adjustment of the purchase price or otherwise negotiated away in the agreement. This leaves the buyer free to take the measures he wishes in the company.

"During negotiations, buyers often realize that with earn-out , they earn-out also earn-out the seller the right to gain insight into and influence the company's operations. Therefore, it is not unusual for other solutions to come into play," says Ulf Steiness, speaking from experience.

In some situations, the parties agree to retain key people instead. This is often the seller, even in medium-sized companies, who stays with the company for a number of years. With such an agreement, part of the purchase price can be settled later if the key people have not resigned 12-24 months after the change of ownership.

Two misconceptions about earn-out selling a business

As an advisor to business owners, Ulf Steiness encounters two common misconceptions about earn-out:

Can it be said that an earn-out can be used as a bonus for the seller?

Ulf Steiness: Earn-out bonuses are NOT the same thing. If the buyer wishes to retain the seller for a period of time, a retention bonus may be included in the employment contract. Earn-out related to the company's results – not the seller's work performance. In addition, different tax rules apply to bonuses.

Can earn-out be considered earn-out form of seller financing?

Ulf Steiness: Earn-out NOT seller financing, but an option for the parties to hedge uncertainty in the transaction. A business transaction can be financed in many different ways – one of them is seller financing, but it has a fixed repayment profile, price, and collateral.