An earn-out is a deal structure in which the seller warrants that expected profit targets will be achieved, in order to justify the sale price agreed to.
Typically the deal will look something like this: The sale price (often a really impressive number) is agreed to, based on past earnings and expected future earnings. The seller typically receives about one third of this price upfront and the balance each year for two or three years, provided the profit targets are reached. Of course this makes complete sense – the seller said the forecast was achievable so why wouldn’t this be a fair approach? The problem is that there are numerous obvious (and not so obvious) pitfalls which all parties need to consider. The first is that the two parties are seldom aligned. The seller is so focused on meeting profit targets that they are not incentivised to grow the business. The buyer on the other hand wants to integrate their new acquisition into their operations, but doesn’t want to implement all the potential synergies because they ‘don’t want to pay for what they bring’. Other less obvious challenges are, for example, the fact that sellers are simply not used to ‘having a boss’. They struggle to work within the parameters of the acquirer’s operations and are unable to access the synergies that they need in order to meet their targets.
So, is there an alternative to an earn out?
We believe there is, provided that both parties realise the need to manage and reduce risk for the other party. The acquirer needs to accept that they are not the only party taking risk in a deal and the seller needs to realise that it is also their responsibility to assist in the reduction of risk for the buyer. The principle is simple: lower risk for the buyer generally means a higher price for the seller.