Failure to agree on price is one of the most common reasons that M&A negotiations reach a stalemate. The buyer is not willing to commit additional guaranteed dollars to a deal and the seller believes the company is being under-valued. In these situations, there may be an alternative: an earn-out. An earn-out is an additional purchase price for a business that is paid based upon performance criteria that are agreed upon by the buyer and seller.
An earn-out can be an effective way to bridge the gap when the buyer and seller disagree on the price for a company. If the seller intends to be an integral part of the management of the business and will have some element of “control” over the operations, an earn-out can be an effective way to earn a higher purchase price for your business. However, if the buyer will quickly absorb the business and the owner will not be a part of the management team, very little, if any, earn-out dollars will be paid.
As with most M&A deal structuring, the details of an earn-out agreement can prove to be challenging. The parties must agree on the performance targets and specifically how they will be calculated. Typically revenue, or net operating income, measures earn-out performance. Utilizing revenue tends to be a cleaner method, as there are fewer discrepancies in the way that top line revenue is calculated. Measurement of bottom line, or net operating income, is more common, as the buyer wants the seller to drive profitability after the sale. However, the calculation of net operating income can be much more complicated, and therefore it is imperative to have a complete description in the legal documents that will describe this calculation.
There are other ways to structure earn-out performance targets, including annual referrals, visits, number of contracts gained and lost, gross revenue, or charges. Our experience is that the simpler the better, and that both parties need to be clear on what the roles will be post sale, and the specific performance criteria.
The key to success is that both parties walk away from the negotiating table feeling they have achieved their most important goals.