In today’s market, buyers and sellers need to be creative when it comes to financing the purchase and sale of a business. Earn-outs offer a financing option that provides for flexibility, incentives for the new owners to do well, and incentives for the seller to see the transition go smoothly.
Earn-outs can be structured in a variety of ways, which makes earn-outs a great vehicle for creative financing. In this article, we will go over 3 different, but common earn-out structures.
For this article, I will use the below numbers so that you can visually see the different earn-out methods.
|Seller Financed Promissory Note:||$500,000|
|Maturity Date:||End of Year 3|
|Payment Period for Promissory Note:||Quarterly|
|Revenues from Year 1:||$1,000,000|
Earn-out with a set principal amount, but flexible payments
The first earn-out structure is where the seller-financed loan, typically a promissory note, has a set principal amount that is due, and the installment payments are what fluctuate over time. In this case the amount that is paid back is the same, but it is the note’s repayment time that could change.
In our example, the seller and buyer have agreed to a $500,000 promissory note that is to be paid off at the end of year 3. That means there will be 12 quarterly payments over the course of the 3 years. The seller and buyer have agreed that the quarterly payments will be 20% of the revenue for the quarter and if there is any remaining principal then it will be a balloon payment at the end. So, the buyer’s payments for the first year would look like the below.
|Dates||Revenue Per Quarter||Buyer’s Payment for Year 1|
From the above chart, you can see that the buyer’s payments under the note fluctuated each month. Some months the seller received more, others the seller received less. There are pros and cons to this type of repayment, and it may not be right for every situation. The pros for flexible earn-out payments are that it provides the buyer with flexibility for when times are hard, and the business is not flush with cash. The pros for the seller are that if the business does well and the transition is successful the seller stands to be repaid faster than originally planned.
The cons for the buyer are that if the revenues (or whatever the measurement is) is not as successful as planned, the buyer could face a large balloon payment at the end that the buyer will need to budget for. The cons for the seller are that the payments could be smaller, and the seller may have to wait until the promissory note’s maturity date to see the full repayment.
Earn-out as an incentive for the Seller
The next 2 earn-out structures are used as a bonus on top of the purchase price to incentivize the seller to see a successful transition to the buyer or as a way for the seller and the buyer to compromise on the purchase price. Essentially, the better the seller sets up the buyer to take over, the more money the seller can earn from the overall transaction. Incentive earn-outs are typically accompanied with a transition or consulting agreement where the seller is contracted to provide their services to the buyer.
There are 2 common options for an incentive earn-out provision – the cliff (or achievement goal) and the timed-percentage. Both can be utilized on their own or combined to make a creative bonus for the seller.
The Cliff Earn-Out
This method is where the seller and buyer agree on a set amount or amounts that the company needs to hit before the seller can earn their “bonus.” Commonly the seller and buyer agree upon a short-term cliff to provide a quick incentive and a long-term cliff to provide an ensured transition. Short-term cliffs offer the seller a fast incentive that is focused on the initial transition from the seller to the buyer. These short-term cliffs usually occur within the first 3 to 6 months of the transition. Long-term cliffs offer the seller an incentive that is focused on ensuring that the seller sets up the buyer and the transition for long-term success. Long-term cliffs tend to occur at the 1 year or 18-month mark.
In our example, the seller and the buyer agree on the same 20% of revenue if certain target revenues are hit, but the 20% will be measured 1 year after closing. The purchase price ($1 million) will remain the same since it is based on the value, but the seller could see an additional bonus at the 1-year mark. The earn-out would look like the below.
|Dates||Target Revenues||Actual Revenues||Earn-Out Bonus|
The above chart outlines the best case and the worst-case scenario. This scenario is the extreme version, but it illustrates that the cliff earn-out can be very hit or miss. The cliff earn-out is a way for the seller to earn an additional bonus for seeing that the buyer is successful in the transition of the business.
The pros to a cliff earn-out are that the seller is incentivized to make sure the buyer is set up to succeed in their new venture, while cons are that the seller can sometimes be drawn back into the business or want to step in (and on the buyer’s toes) to ensure a larger payout. The pro for the buyer is that the buyer is ensured that the seller has some motivation to see that the transition is successful and that the seller doesn’t check out once the deal closes. The cons are that buyers may have difficulties with the seller being present and letting go of their “boss” role.
The Timed-Percentage Earn-Out
For the time-percentage earn-out, the seller and buyer agree upon a percentage at certain intervals over a set period of time. This structure lends itself well to set goals that both parties believe should be hit for the buyer to be successful. While there are numerous ways to structure the timed-percentage earn-out, in the below example the payment is an all-or-nothing earn-out where if the target is not hit the seller does not get paid, but the seller has multiple chances to hit the target.
|Dates||Target Revenue Per Quarter||Actual Revenue Per Quarter||Buyer’s 20% Payment for Year 1|
In this scenario, the seller could have earned up to $200,000 but encountered some hard quarters (Q1 and Q2) where the target was not achieved. As you can see, there are pros and cons to a timed-percentage earn-out and when the seller and buyer are negotiating the earn-out terms the parties need to be aware that goals might not be met. However, the pros for the seller are that the seller could see significant gains if the buyer does well, and the cons are that the seller may earn little to nothing depending on the terms. For the buyer, the pros are that the seller is consistently incentivized to help over time, but the cons are that the seller could become unmotivated based off hard times.
Earn-outs can be a great way to get creative with financing, either through flexible payments with fixed prices or through incentive payments to ensure a smooth transition. There is no one-sized-fits-all or standard earn-out, each is as unique as the business. While structuring an earn-out can seem daunting, the parties should see it as an opportunity to find financing that fits their unique needs and deal.
The above article is for general information purposes only and should not be relied upon as specific legal advice. This article, or contacting Apex, does not in any way form an attorney-client relationship. If you have any questions or would like to learn more, please contact Tara Vitale at firstname.lastname@example.org.