Your browser will redirect to your requested content shortly. Your browser will redirect to your requested content shortly. Sign in if you’re already registered. When there’s a valuation difference between what a buyer thinks a business is worth and what the seller expects to profit, an earn-out can bridge that gap. Christine Lagorio-Chafkin is how The Hell Earn Money writer, editor, and reporter whose work has appeared in The New York Times, The Washington Post, the San Francisco Chronicle, The Village Voice, and The Believer, among other publications.
She is a senior writer at Inc. What’s the value of your business? That depends on whom you ask. Ask potential buyers, especially when they’re being cautious in tough economic times, and it might not meet your expectations. When a seller’s expectations aren’t being met by potential buyers, including an earn-out provision in the acquisition contract can help narrow the price-expectation divide. A common feature of many acquisitions, an earn-out stipulates that the original owners of a business are paid for the sale of their company, following which they are contractually obligated to stay with the company through a transition period, and they are provided with the incentive to have a demonstrable effect on the company’s financial performance going forward.
Brian Mutert, founder and CEO of San Francisco-based investment bank Stratagem, which specializes in mergers and acquisitions, says earn-outs can benefit both buyers and sellers. It’s a way for the buyer to put some skin in the game for the seller after the deal closes, and to provide some financial incentive for them to work hard in terms of the company’s business after they close the deal,” he says. In a situation where the seller might believe there is a great opportunity for future growth potential, they can take some added benefit in the transaction. Dig Deeper: What’s Your Business Worth in a Buyers’ Market? When there is a gap between an owner and a potential acquirer in the perceived value of a business, it is usually caused by the expected future growth of the company. But as a small business owner, it’s necessary to step back and ask yourself: If your expectations are higher than those of your buyer, why is that? After all, it’s commonly known that roughly three-quarters of all mergers and acquisitions fall short of the expectations that are stated when the deal is announced. And about half of all deals result in a loss of value for the buyer’s shareholders. Being equipped with solid expectations for your businesses success over the next five years can prepare you well for negotiating an earn-out.
An earn-out is a contingent payout, which essentially involves shifting some of the purchase price to be paid in the future on the realization of future earnings or some other benchmarks of success,” says George Geis, an associate dean of the Executive MBA Program at UCLA’s Anderson School of Management. So the owner needs to be wiling to delay some of the price, and be aware they might never get it. If your company had a track-record of performing at or exceeding forecasts in the past, this fact should give you added negotiating power. Knowing expectations is vital is because the range of earn-out terms that could be offered is vast. A buyer might agree to pay 90 percent of the total purchase price you desire upfront with the remaining 10 percent paid in stock or cash after a year of earn-out time.
50 over five years during which time the owner must agree to stay with the company and optimize its performance. 350 million more promised through a series of earn-outs. For high-tech and service businesses with high-growth potential, a typical deal might include an upfront payment from an acquirer of between 60 and 80 percent, with the balance paid over time possibly as an earn-out tied to performance. Geis estimates that, in the post-dot-com-boom era, the owners of private companies regularly have been taking between 40 and 45 percent of the total pay-out through an earn-out agreement, according to surveys. For entrepreneurs looking for a quick sale of their business, the simple st earn-out is none at all. A CEO must recognize they will not be in control of their own destiny in any part the same way they were,” Mutert says. They will have new bosses and will have to march to a new set of rules than they had to when it was their own company. Many earn-outs depend on an extremely complicated matrix of variables and goals.
This should be avoided if possible. Earn-outs are most effective as an incentive for the seller when the size of the payout is determined based upon one or two simple variables. A buyer who constructed a complicated set of goals covering earnings, customer retention, and myriad other circumstances should be challenged. These conditions might not be fully under your control should you accept the earn-out.
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