Buying a Business: Understanding How Earn Out Structures Work?
Structuring an Earn Out
“Earn outs are a great mechanism to help protect a buyer from potential uncertainties in a business, but can be complex and not always the best option”
When you are looking to buy your own business, depending on the deal itself (as no two deals are the same), you have a variety of ways to get creative when it comes to paying for your business. Vendor Notes and Earn Outs are commonly used independently of each other, and each have their own uses when it comes time to structure a deal. It’s important to note here that not all sellers will offer an Earn Out, or even a Vendor Note, so it’s all about how the deal has been structured and how the business has performed. Investopedia also has a great page on Understanding Earn Outs.
When buying your business, you need to have a conversation with the seller about their current situation and ask what they would be open to. We have talked about different financing options in our Blog – Understanding Financing When Buying Your Business, but not all financing works for every deal. Very often a bank may not finance a deal, or a seller may request for a Vendor Note only.
1. Earn Out Structures and How they work
An Earn Out is a contractual obligation provided to the seller of a business, to obtain additional compensation or part of the final sale price, on achieving certain future KPI’s or financial goals. The most common Earn Outs can be based off revenue or Normalized EBITDA Targets. The latter is a little trickier, as corporate lawyers need to clearly state what that Normalized EBITDA should include. There are several ways to calculate an earn-out. In most cases, the business is valued by the brokers, and a lump sum payout is determined. Then these payments are spread out over several years.
In smaller businesses, Earn Outs are more common when the business is tied completely to the owner, or if the future potential of the business isn’t as clear. In these situations Earn Outs are aimed to eliminate certain uncertainties for the buyer and the seller receives the benefit of the future growth of the business. It is really important to get advice from your lawyers and accountants when structuring an Earn Out as they can get complex.
2. Pro’s of using an Earn Out when buying your business
From the buyers point of view the Earn Out ties the sellers future earning to the businesses performance. It is understood that both parties benefit when the business is doing well. The financing is spread over a few years and if the business doesn’t perform as expected, it protects the buyer from over paying for the business. It’s important to note here that a lot of sellers don’t like Earn Outs as it leaves potential money in the hands of a new business owner, who may not have the same knowledge or quality of relationships with employees, customers and suppliers. Therefore, Earn Outs have a large trust factor between the buyer and seller that needs to be taken into account.
3. Con’s of Using an Earn Out when Buying your Business
While Earn Outs work well for buyers to protect them from certain business performance uncertainties, they can be tremendously tricky to structure. If a business has done well over the past few years, you might turn a legitimate seller off by requesting an Earn Out. Most sellers prefer Revenue Earn Outs as they can be less cumbersome and ambiguous, as Normalized EBITDA Earn Outs can be manipulated. Earn Outs need to be very well explained in the Letter of Intent and/or the Final Purchase Agreements. We have seen situations where Earn Outs are not worded well, and your corporate lawyer needs to have experience working with them.
Disclaimer: This article is a very brief description of how Earn Outs work, and they can get quite complex, and aren’t for every deal. Its important to consult your corporate lawyers and accountants about how Earn Outs in your local market work. An earn-out is a complex agreement and all the elements must be considered carefully.
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