What is an Earn-out? Is it a Good Option?

An earn-out provision in a sale agreement provides business owners future payments based upon company performance after the sale. Often when an owner believes his business is poised for exceptional growth and thus worth more than average market values, earn-out provisions can bridge the gap between the buyer’s valuation and the seller’s expectations.

Here are some reasons an earn-out might be an owner’s best option:

  1. The owner/seller is critical to the future success of the business.
  2. Value is based upon future earnings that are too speculative for the buyer. (High growth rate due to market flux, new product)
  3. Buyer does not have adequate capital.
  4. Seller wants to participate in future earnings.
  5. Potential tax reasons (ordinary income vs. double taxation)

A simplified example follows:

  1. ABC Chemicals has developed a soon-to-be patented product that will increase profits drastically once introduced to the market.
  2. The owner of ABC, Tom, wants to sell his company now before the product goes to market.
  3. By market standards, ABC is worth 20M, but Tom believes in the next two years the company’s net profit will grow by 1M each year. Tom believes this growth at that time will put his company’s value around 30M.
  4. Instead of waiting two years to sell his company, Tom and the buyer agree to place the Total Enterprise Value (TEV) at 30M.
  5. The deal is structured so that Tom receives 20M at closing and 5M for two years, assuming he hits his target growth of 1M per year in net profit.