How Earn-Outs Can Work Well in the
Purchase of a Business
by John W. Schuster of Caliber Law, s.c. 920.292.0000
I frequently get asked by potential buyers of businesses what value and role an earn-out structure can play in making a purchase of a business a success.
My answer is that an earn-out – where a portion of the purchase price for the business is made contingent upon the business meeting certain metrics after the sale – can be extremely valuable when it is properly used as a mechanism to bridge a gap between what the buyer and seller believe the value of the business is.
For instance, it is extremely valuable when it enables the buyer to agree to the seller’s negotiated asking price, but allows the buyer to hold back the difference between the buyer and seller’s valuation of the business, and make that amount “at risk” based on a metric such as revenue of the business over the next two to five years meeting a specific performance mark. If the business performs at or above what is expected, the seller gets paid the at-risk money, and if the business earns less revenue than expected and agreed upon by the parties, the buyer gets to pay the reduced purchase price by not having to pay the seller note, or the seller note getting reduced by a set interval each year.
This allows the buyer to pay the bigger purchase price based on actual performance of the business after the sale with revenue that buyer actually captures, and the seller has a motivation to make sure it was a successful and smooth transition to the buyer, but also gets the increased purchase price that the seller wanted based on actual performance of the business.
I usually recommend basing an earn-out on something like revenue because it is not based on what expenses the buyer is incurring in the business, and is by far the easiest metric to track, i.e., the company either did or did not make the revenue.
There are a lot of other great options, and a properly structured earn-out can lead to success and equal motivation for both the buyer and seller, if properly structured by someone who structures earn-outs on a regular basis.
Atty. John W. Schuster, J.D., MBA is the owner and an attorney at Caliber Law, S.C., a law firm located in Oshkosh which specializes in business law and real estate. Schuster helps business owners start, protect, buy, sell and grow their businesses.