Disagreements emerge in any negotiation. Whether you are looking to sell your car or sell your company, finding a common ground takes effort and time. For transactions in the middle market, the biggest friction is typically around price.
Despite months of negotiation, buyers and sellers often have trouble agreeing on a specific purchase price. This misalignment on price can cause one or both parties to step away from the negotiation process. But the disagreement does not need to end the entire process. Rather than scrapping the transaction, one strategy to bridge the gap between the buyer and the seller is to use an earn-out.
With an earn-out, the buyer makes additional payments to the seller, after the sale, dependent on the performance of the business and the owner’s involvement in the business. Earn-outs are essential to closing deals when the buyer and seller just can’t agree on an exact price. They are designed to protect both parties and ensure that everyone receives fair value for the business.
Below are four key ways in which an earn-out can help facilitate negotiation agreements between business owners and investors:
- Shorten the negotiation time. One of the biggest advantages of an earn-out is that it helps speed up the process of selling your business. Since each party is essentially “agreeing to disagree,” the earn-out can restart stalled processes and limit the time spent haggling over price. This can drastically reduce the efforts and headaches associated with selling your business, lead to a better relationship with your acquirer, and potentially reduce some of the fees related to a M&A transaction.
However, earn-outs do require some negotiation themselves. While the exact terms of the contract can vary, it is estimated that 25% of M&A transactions in 2013 included an earn-out. The average length of the payout was 12 months, but 21% lasted longer than 36 months.
- Get full value for your business. While you might have a smaller purchase price initially, an earn-out actually allows you to receive the full price for your business post-acquisition. Earn-outs can act as a form of dividend payment, often eliminating the challenges that emerge when you rush to sell the business in one payout. If the business performs stronger than the buyer anticipated, there is a likelihood that the sum of the earn-out will exceed the one-time payout you would have received at the time of the negotiation. This is particularly true if you are selling a strong business in a down market — the earn-out can get you closer to what your business might be worth in a strong market.
- Ensure a seamless transition. During an acquisition, an abrupt departure by the owner can create some cultural uncertainty. Employees are wary about their ongoing roles, the company, and their future. In an earn-out, however, you are typically required to stay involved in the company during the transition. This can allow you to create a seamless transition of ownership and retain the ability to include key employees at your company in the knowledge loop. Your decision to stay on, will not only help serve as a bridge between current employees and the new owners, but will also demonstrate to your key executives that you are not rushing to sell the business; you still have confidence in its performance.
- Demonstrate confidence to the investor. Earn-outs are appealing to an investor because they help prevent the firm from overpaying for the company. Since the earn-out is only paid when the company exceeds pre-defined performance thresholds, the investor only has to pay if they underestimated the value of the company. By agreeing to an earn-out, you demonstrate that your are very confident that your business will outperform their conservative estimates. This confidence can be a good sign to the potential investor, indicating you are not hurrying to jump from a sinking ship.
Before committing to an earn-out, be sure it is the payment structure you really want. If there is a significant difference between your price and the buyer’s price, it is important to consult with your M&A advisor and make sure you are not overly confident about your price. There are a lot of factors that are considered in valuation, and it is important not to overlook them. Also work with your advisor to create a graded earn-out structure, so your payment is relative to actual performance — you don’t want to get 0% of your earn-out for just missing the target.
Recent research also reports that 40% – 45% of a payout can come through the earn-out. As a result, it could be years before you realize the full payout of your transaction and mean a reduced initial payment. If you are looking to exit in a hurry, an earn-out does not make sense.