Has anyone ever encountered a "make up provision" in an Earn Out?

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October 29, 2021

by a searcher in Los Angeles, CA, USA

Has anyone ever encountered a "make up provision" in an Earn Out?

Seeking comments from our community in reference to "make up provisions" w/ earn outs. To the extent you may be aware, what terms did they/you use and how was it beneficial for the buyer/seller?

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Reply by a searcher
from Northwestern University in Chicago, IL, USA
Not sure if we're confusing any nomenclature here, but the way I read "makeup provision" is where you have a two-part earnout (one in FY+1, one in FY+2) with one target that builds off the first. For example, say revenue today is $100MM and you have an earnout that pays if you achieve $110MM of revenue in year 1 and $120MM of revenue in year 2. Implicit in this build is that the second target ($120MM) assumes that the first target is reasonably achievable and will be hit.

Now, say you undershoot the first target in year 1 and achieve $105MM of revenue - the earnout will fall out of the money. However, assume now that you knock it out of the park year 2 and achieve $130MM of revenue. In this case, the owner will likely turn to you and say "hey, we didn't hit the year 1 target, but we beat where you thought we would be in year 2. I feel like I deserve the value of the first earnout as well".

Up to you how you would want to deal with something like this, but my advice would be to pay out both earnouts. If the seller is involved in the business long-term, withholding the first earnout is a quick way to burn a bridge. At the end of the day, in the scenario above, you're right where you wanted to be at the end of year 2, so don't penny pinch your way into a venomous relationship with your seller. (All that said, you can definitely find scenarios where it would make sense not to pay the first earnout - won't dive into that too much now)
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Reply by a searcher
from University of Western Ontario in Toronto, ON, Canada
During my time in Private equity, we used a "make-up provision" pretty regularly for lower-middle market deals. Whereby, if the earn-out is multi-year then the seller has an opportunity to "make-up" for a missed earn-out target in one year, if the target is then overachieved the following year. For example, if the earn-out is paid out over 2 years and the target is achieving $50mm in revenue in each year, but the first year the achieved revenue is only $45mm but the second year is $55mm then the seller would be made whole as part of the second payment. In these cases, it was mostly used as a negotiation tool if the seller was uneasy about the earn-out, in general.
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