What’s an Earn Out? How It Works, Benefits, & Strategies

When it comes to mergers and acquisitions, both sellers and buyers want to receive the maximum possible value. Quite often, the two parties disagree despite thorough negotiations and have to abandon the transaction.

To reduce the chances of abandoning the transaction, you can agree to an earn out system that benefits both seller and buyer. We'll explore how the system provides flexible pricing that ensures the seller keeps earning based on the company's future performance after the sale.

Since earn-outs in M&A processes can be challenging, working with professionals is necessary to ensure you get the best value for your company.

At Exitwise, we can help you interview and manage an exceptional team of M&A experts who will ensure you get the best deal structure and highest valuation price possible. Book a free consultation with our advisor today to get started.

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What is an Earnout?

An earnout is a contractual agreement wherein the buyer of a company agrees to pay the seller the entire purchase price (or a portion of it) in the future once the target company achieves predefined operating milestones or financial metrics after the transaction has closed.

Earnouts are an effective tool for mitigating risks and bridging the valuation deadlock that sellers and buyers usually get into and are forced by circumstances to kill the M&A process.

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How Does Earn Out Work?

An earn-out is important if the seller and buyer disagree on the value of the business and how risks should be allocated between them.

The system is typically used when acquiring a privately owned company and rarely in a publicly owned one.

The main basis of an earn-out agreement is that the seller receives additional payments in the future based on the performance of the business after they sell it.

Here’s how it works:

• The seller and buyer agree to use either financial or operational metrics to gauge the company's future performance and determine future payments.
• The financial metrics can be based on gross profit, gross revenue, or EBITDA. Buyers prefer the EBITDA metric because it is a better indicator of the profitability and value of the business.

Conversely, sellers prefer the gross revenue metric because it is less prone to manipulation by the buyer.

• The buyer will pay the seller an agreed-upon amount of money once these milestones or financial metrics are achieved in part or whole during the duration of the agreement.

How is an Earnout Taxed?

Earn-out payments can have varying tax implications, depending on how you structure the business sale agreement:

• Generally, earn-out payments attract ordinary income tax or capital gains tax, depending on how the earn-out is structured.
  • You'll attract a capital gains tax if the earn-out is considered part of the purchase price.
  • If the earn-out is seen as part of compensation income when the seller remains an employee of the new acquirer, it attracts ordinary income tax.
• The top income tax rate currently stands at 37%, while the highest long-term capital gains tax rate currently stands at 20%.
• Generally, any stock or business asset sale with an earn-out provision should be reported as an installment sale.

Federal income taxes apply to installment sales, depending on whether the maximum possible selling price and the earn-out period can be determined.

The tax implications of an earn-out system can be complex and daunting, not to mention sometimes unfavorable to you as the business seller. Be sure to consult your tax advisor before you agree on an earn-out payment plan.

At Exitwise, we can help you find the best M&A tax accountants. Schedule a free consultation with our advisor to get started.

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How to Structure an Earnout?

There isn't a definite earn out structure that applies to every transaction. Instead, the buyer and seller agree on a customized structure that meets their needs.

Here's what a typical structure entails:

• The earn-out is usually structured as a portion of the final purchase price and is contingent upon realizing specific operational aspects or financial metrics.
• A specified length of the contract.
• The roles the executives will take up in the company once the sale closes because the performance of the company is tied to the management and critical employees.
• Deciding which financial metrics will be used to determine the earn-out payments. You can combine different metrics, such as revenues and profits.
• Agreeing on the specific accounting system for gauging the financial metrics, such as the Generally Accepted Accounting Principles (GAAP).
• Agreeing on dispute resolution mechanisms.
• Agreeing on the payment structure when the earn-outs will be paid, which can be at intervals during the duration or at the end of the duration when the company fully or partially meets the agreed performance aspects.
• Agreeing on the form of earn-out payments, which can be flat amounts, multiples of the amount that exceeds the target, or percentages of the earn-out targets.
• Deciding the impact of significant events. Agree on what happens when the buyer fires the seller if they stay on or when the buyer sells the company during the earn-out duration.

What would happen if the buyer merges the company with another, making it difficult to measure the earn-out metrics independently?

• Providing security for the earnout, where the buyer puts some money in escrow or pledges the company's assets to the seller should the company fail to honor the earnout provisions.

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Pros and Cons of Using Earn-Outs

Here are the advantages and disadvantages of the earn-out payment system from the seller's perspective:

Pros

Cons

You receive additional payments and the opportunity for a higher sale price you wouldn't get at the buyer's current valuation of your company.

Agreeing on the specific terms of the agreement, including the earn-out amounts and performance metrics, can be difficult.

You spread your tax liability over several years, reducing the tax impact.

You might have to contribute your expertise to improve the company, which may limit your options if you want to move on.

You mitigate the risk of receiving lower payment for your business, which may perform exceptionally well in the future.

Earn-out plans are complex to negotiate and execute.

You save face because you don't have to abandon the sale due to differences in expectations between you and the buyer.

If the buyer is dishonest, they may manipulate business performance to alter or eliminate the earn-out payment at a particular period.

While we have only examined the pros and cons of an earn-out to the seller, note that it also has advantages and disadvantages for the buyer. The buyer will want to maximize their benefits, which could lower yours.

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Key Components of an Earn-Out Agreement

An earn-out agreement has the following seven critical elements:

1. Total Purchase Price: This is the total amount the seller will receive. Buyers usually agree to pay the seller's asking price or 70-80% of it to maintain the upper hand in negotiations.

2. Upfront Payment: This is the portion of the agreed purchase price that the buyer will pay when the transaction closes. Buyers usually equate this amount to the Enterprise Value they have calculated for the company. Some may lower it to reduce the risks further.

3. Contingent Payment: This is the difference between the total purchase price and the upfront amount.

4. Earn Out Duration: This is the period the earn-out will last. It's usually 1-5 years, with an average of three years.

5. Payment Method and Frequency: Payments can be made in cash or stock. You can receive multiple payments yearly or one lump sum at the end of the earn-out period.

6. Performance Metrics: You must agree with the buyer on the metrics you'll use to evaluate the company's performance.

7. Predefined Payments for the Target Metrics: You'll need to agree beforehand on the corresponding or consequential earn-out payment for each predefined metric.

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What Factors Influence an Earn-out Payment?

The amount you receive as an earn-out payment is tied to the performance of your company, which may fluctuate based on factors such as:

• The Buyer's Strategy: The buyer's business acumen and expertise can make or break the earn-out plan. If their business strategy causes the company to incur losses, your earn-out payments will reduce or fail altogether.
• Size of the Business: A larger business or company can enjoy economies of scale and a significant market share, leading to higher profits that enable the buyer to fulfill your earn-outs.
• Nature of the Industry or Sector: A seasonal sector may cause fluctuations in your earn-outs because you may not always hit the performance targets during low seasons.
• Retaining Critical Employees: If the buyer retains you as the founder or CEO, as well as other crucial employees, the chances of hitting performance targets are higher. As such, your earn-outs will be payable in full.

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Top 4 Strategies for Negotiating Earn-Outs

We’ve already seen that earn-outs are complex and challenging to formulate.

Here are some tactics to use to negotiate a better deal:

1. Ask for Escrow: Ask the buyer to place the contingent payment in an escrow to ensure it will be available for disbursement to you when the earn-outs are due once the set metrics are achieved.
2. Retaining Key Employees: Ask the buyer to retain the management team and other key employees to safeguard your interests. They will ensure the buyer acts in good faith when running the business and doesn't terminate the company for flimsy reasons.
3. Ask for Accelerated Earn-outs: Reduce the earn-out duration and clear the contingent payment faster by asking the buyer to accelerate the earn-out payments. You can make this request if the buyer sells the business during the period, breaches your agreement, fires key employees without good cause, or your company achieves the performance targets early.
4. Request to Retain Leadership Autonomy: If you remain in the company under the acquirer, ask to maintain your independence as the founder or CEO so it's easy to make decisions toward success and reach the set performance targets.

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Frequently Asked Questions (FAQs)

Let's end the discussion with some FAQs on earn-outs in M&A:

What’s the Difference between a Seller Note vs Earn Out?

A seller note is a financing option in which the seller loans the buyer up to 25% of the purchase price with interest over three to five years.

Unlike an earn-out, a seller note doesn't rely on the business achieving set performance targets. Instead, the seller receives part of the purchase price through several debt payments.

What Industries Commonly Use Earn-Out Agreements?

Earn-out arrangements are common in high-growth industries that cannot easily predict future profitability and revenues.

These industries include healthcare, advertising, technology, and marketing.

Can Earn-Outs be Applied in Cross-Border Transactions?

Yes, you can apply earn-outs to cross-border transactions. However, the complexity of the transaction increases.

You'll have to consider additional aspects such as applicable laws, fluctuating exchange rates, monetary devaluation, and applicable accounting procedures.

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Conclusion

If you structure an earn-out agreement correctly, it can help you resolve valuation or pricing differences with the buyer instead of abandoning the deal.

It's a win-win situation that protects the buyer from downside risk and gives you a higher purchase price than ordinarily possible.

But to ensure a favourable earn out deal, you’ll need expert advisors on your side.

At Exitwise, we can help you recruit and work with your dream M&A team to ensure you get an advantageous deal structure and the highest sale price possible. Reach out to us today for a free, no-obligation consultation.