In an ideal world, all business deals would be pretty straightforward. The buyer and seller would agree on a price and shake hands, and then the buyer would send the seller a big cheque in the mail. The buyer gets a brand new business, the seller moves to a tropical island, and everyone is happy.
Things are, of course, not so simple. The buyer will almost certainly need to secure financing for the deal. Negotiations are another certainty; the buyer and seller may disagree on the value of the business.
Earn-outs are a method of dealing with this complexity. Part financing and part negotiation tactics, they give buyers and sellers a way to complete the deal even amid disagreements over valuation. In this article, we’ll explain what an earn-out is, the advantages and disadvantages of earn-outs, and more. Let’s get started.
What is an earn-out?
An earn-out is a stipulation that the buyer of the business pays a percentage of the profits from that business to the seller. The structure of an earn-out can vary. The buyer and seller will negotiate:
The period of time the earn-out will be paid out over
How often the earn-out will be paid
The maximum amount the buyer has to pay
The minimum amount that the buyer has to pay
The method used to calculate the earn-out
An example of an earn-out
A business is purchased for $1 million dollars, with the stipulation that an earn-out be paid to the buyer over three years (in addition to the purchase price of the business). The two parties agree to an earn-out of 10% of EBITDA each year, with a minimum payment of $100,000. They also agree that the maximum earn-out over the three years will be $300,000.
This is a simple example of how an earn-out might be structured; more complex earn-out deals might include minimums, maximums, and percentages that vary based on profit thresholds. There are practically endless ways of structuring earn-outs. They add a degree of complexity to the deal - so why would buyers and sellers want to use them?
The advantages of earn-outs
When a buyer and seller cannot agree on a price, earn-outs are an excellent compromise. If the seller is right in valuing the business more highly than the buyer, they may earn more; they’re paid based on the profitability of the business. Conversely, if the business is less profitable than the seller anticipated, the buyer will have to pay less.
There are additional benefits to earn-outs for both buyers and sellers:
The seller will be more invested in helping the buyer succeed, as they’re paid based on profitability.
Earn-outs decrease the initial price of the business, allowing the buyer to spread out payments over time.
Lower payouts in years with fewer profits reduce the buyer’s financial burden.
Capital gains tax is spread over time.
The deal may be closed more quickly, and the option of earn-outs can increase the pool of buyers to choose from.
The disadvantages of earn-outs
Most of the disadvantages of earn-outs are pretty self-explanatory: The seller may make less than they anticipated, and the buyer may pay more than they’d anticipated.
Another potential disadvantage of earn-outs is conflict. The seller may grow dissatisfied with how the buyer is running the business should the earn-outs be lower than expected. Earn-outs are also inherently more complicated than some other deals; this can lead to frustrations and sometimes litigation.
Canadian business brokers like Jason Brice can help you structure earn-outs and avoid any post-sale conflict. Interested in selling your business? Call Jason Brice today.