Forbes Magazine said recently that the number one reason businesses fail to sell is because the vendors have an unrealistically high expectation of how much the business is worth. Of course, vendors would argue that buyers have an unrealistically low expectation of how much the business is worth. Nevertheless, it is par for the course for negotiations to fall down simply over price.
Rather than walk away from the deal, however, there is a way of bridging the valuation gap. It is by using an "earn out."
An earn out is a mechanism where part of the purchase price is payable after settlement, contingent on the results of the target during the earn out period.
An earn out is a mechanism in your sale agreement where you agree that 15%-30% of the purchase price can be paid over time after settlement so long as certain KPIs are reached. The way that earn outs arise is something like this: You believe that your business is going to increase sales 25% year on year for the next three years because of a new product you have just released. Thus, you want $20M for your business. The buyer of your business doesn't see it that way. The buyer simply looks back at the past three years worth of numbers and sees sales increases of 8.5%. Why should the buyer pay you for something that hasn't materialised yet? The buyer only wants to pay $17M. What do you do? Walk away? What if there are no other prospective buyers?
The simple solution is to say to the buyer:
- "I will sell the business to you for what you are offering. If, however, the sales materialise as I predict, then you pay me more money after the sale of the business and in accordance with a formula that we agree."
If you are wrong, then the buyer hasn't overpaid. If you are right, then you get some of the upside, the buyer gets most of the upside - and so everyone is happy.
There are two reasons you and the buyer will disagree on price. One is that you know more about the business than the buyer does. The other is that you both simply disagree - independently of who knows what. These two scenarios can be stated as follows:
- One is where one party (usually the seller) has more information about the target deal value ("private information setting") where that party thinks the target is worth more (or sometimes less).
- The other is where both parties just can't on the valuation of the target ("non-convergent priors setting").
So the earn out is simply a way of conditioning the payment from the buyer on verifiable information that is available to both parties after settlement. This conditional payment solves the problems of both:
- Private information, and
- Non-convergent priors
Difference to Post Purchase Adjustments
In a post-purchase adjustment payment, the valuation of the business is basically agreed, but there are payments from one party or the other to balance up things like movements in:
- Stock-in-trade between the contract date and the day of settlement, or
- Net working capital.
In an earn out, by contrast, the parties agree on post-settlement KPIs such as EBIT, EBITDA, net income or revenue. Then, the amount that the vendor receives after settlement depends on whether these targets are met. Earn outs vary, but the standard period in Australia is between 1-3 years.Â The amount of the earn out can be between 15%-30% of the total deal value. As a rule of thumb, the lower the earn out percentage, the better the negotiation position of the vendor was during negotiations. Either that, or the vendor mispriced the deal.
So in essence, the earn out is a mechanism for rewarding the vendor if the vendor's projections turn out to be accurate. Earn outs also protect the buyer if the vendor's projections don't come to pass. Earn outs are a way to bridge the valuation gap when the business:
- Has a limited operating history but bright prospects,
- Has had flat or decreasing earnings but a new product or revenue stream that has not yet proved itself, or
- Is asset light so the buyer is not able to obtain financing required to buy it out.
Why Would a Buyer of a Business Use an Earn Out?
Not only do earn outs help buyers meet the seller on the question of price, they reduce the chances of the buyer overpaying for business because the buyer can withhold future payments if the business doesn't perform as promised.
Another advantage is that an earn out also operates as a financing mechanism by:
- Reducing the amount paid at settlement, and
- Allowing the purchaser to finance the purchase out of future earnings of the business it just bought.
Another effect of an earn out - at least when the vendors are also managers of the business - is that the earn out keeps the vendors employed there for the earn out period (one to three years on average). This has the effect of aligning the vendors' interests with those of the purchaser because:
- The vendors want the business to do well so that they can get their final pay out, and
- The buyer wants the business to do well so that it can justify the amount it just paid for the business.
Another way that an earn out is good for the buyer is that it provides security for breach of warranties and indemnities in the sale and purchase agreement. If a warranty or indemnity has been breached, then the buyer can deduct the damage or value of the breach from the money to be paid under the earn out.
Advantages of Earn Outs to Sellers
The main advantage of an earn out for a seller is that it increases the chances of selling the business. Not every business can be sold. In fact, many businesses valued between $1M -$5M can't be sold at all. So if you have a mechanism for getting agreement on price (especially if there are no other buyers), then you should take it. In a perfect world, the consideration received at settlement is all the money the seller wants - the earn out is a bonus.
There are a few more advantages of earn outs for the seller:
- When the seller knows the upside in the business but can't articulate it convincingly to the buyer, or is unable to convince the buyer that it will happen, the seller still has a chance of getting a better price than it would when the consideration is fixed,
- The seller can "take some money off the table" on the day of settlement, and
- The seller can share in part of the upside of the business in the future.
Disadvantages to Both Buyers and Sellers
I have been negotiating earn outs for many years. They haven't got any faster to negotiate or to agree with the parties. The difficulty is in agreeing how the earn out is going to be calculated. Sometimes I think the more people know about earn outs, the longer they take to agree. Even when they are agreed, there is a whole world of pain when the lawyers have to draft clauses that:
- Reflect what has just been agreed, and
- Work properly in the future when the the business, the buyer and the seller are in entirely different circumstances than they are at settlement.
The real issue underlying all difficulties in earn outs is the interests of the seller and the buyer are entirely different. Despite what everyone says about alignment, the fact is sometimes the buyer doesn't want the business to do well because it has to pay out more money. The seller, on the other hand, always wants it to do very well so that it gets a bigger payout. This can lead to sellers who are still in management positions taking short term decisions that increase earn out KPIs, but damage the business in the long run.
These sorts of misalignment give rise to disputes over earn outs.
As a Vendor, Do You Really Want to Work for Someone Else?
One (mainly psychological) problem is that founders who build successful companies and then sell them are often unable to work for the company to which they just sold their business, even if it is just to obtain the full earn out. They are not company people, they are entrepreneurs. Trying to make them follow big company protocols and procedures is just too hard. When that happens, the earn outs tend to fade away.
If the buyer and seller don't agree on valuation - and they probably won't - then an earn out is a way of bridging the valuation gap. That last 15%-30%, however, takes a lot of negotiation and even more careful drafting and there are very real risks that seller will never get the full amount.