Looking for ideas on how to structure an earn out

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17

Reply by a searcher
from Ohio State University in Chicago, IL, USA

Hi there, replying based on Luke's tag. I've worked on transactions with earn-outs, including some unique structures. Happy to see what specific input I could offer if you'd like, ^redacted‌. redacted For others I will share some general perspectives I have learned:

- It is sometimes challenging to align interests between buyer and Seller with an earn-out. Do you tie it to revenue, to EBITDA, to something else? Would a revenue earn-out incentivize sales growth at the expense of profit? (I.e., lowering pricing to increase volume, shifting product mix to less profitable areas for growth). Would an EBITDA earn-out focus the business so closely on profitability in the current period that investments for future growth are not pursued? Will your decisions as a business manager be challenged by the Seller post-close because they could impede the earn-out?

- Is the Seller going to be able to influence the performance of the business going forward? Will they remain a manager with P&L responsibility, or just an advisor/employee? In my deals, earn-outs can be a more compelling option if the Seller feels they can influence the business to earn the money. The incentives I mentioned above come into play.

- If the Seller will not be able to influence the business as much, you may end up having a more detailed agreement which lays out how the business will be managed post-close to protect both sides. You probably cannot make decisions that could negatively impact the earn-out for the Seller. You ability to manage and grow the business could be restricted somewhat. I have had to agree to not reduce headcount or alter the cost base for a period of time, for example.

- Have you considered offering a reinvestment of some portion of proceeds to the Seller, so they can earn more money when you sell the business? I like this option if you can accommodate it. If the Seller reinvests along side you in some pari passi fashion, everyone will be aligned around future equity value and the value created in a successful exit, vs. making short term revenue or EBITDA driven decisions.

- Have you considered other structures to provide value to the Seller post close? A royalty on sales, a consulting agreement, real estate leases if property is owned by the Seller, etc., can all provide some value.

When I worked in private equity, the firm avoided earn-outs based on revenue and EBITDA as a rule due to the points I raised in my first bullet. They thought equity value alignment via reinvestment is the best option. I have employed earn-out structures in my corporate acquisitions more frequently, and we tried to keep them short term, included both revenue and EBITDA metrics, and tried to be thoughtful and comprehensive in the agreement.

Last point: an attorney once told me that all earn-outs are eventually paid. Either the business performs and the money is due, or the business underperforms and the Seller sues for the consideration and wins. But this lawyer was adamant that you should always expect to pay it out.

Reply by a searcher
from University of New Hampshire in 101 Rocky Pond Rd, Hollis, NH 03049, USA

A number of people have already made comments about needing absolute clarity in the language of how the earn out is paid however having done a number of these specially with PS companies - the key point Is it paid based on top line, operating or net income? Sellers will want to get paid from higher in the stack since they can't control the expense side let alone any financing costs. Buyers want to pay out based on as low in the stack as possible to conserve cash. I've negotiated a number of deals where it is calculated about mid-way (aka operating income) if there is agreement on normal business expenses. Since it is a PS company the larger I would push for a much larger earn out since sales are most likely relationship based.

The other big factor is retention of key personnel. If someone critical leaves within the first###-###-#### months that's going to have an impact on short to mid term revenue therefore that should be taken into account in the earn out calc (seller needs to incent key people to stay while the seller develops rapport with the team and with clients). I acquired a number of PS firms at EMC, Cisco and smaller companies and we always took loss of the key delivery members into the calculation. There is a reason that PS firms in general are only valued at 1.5 to 2.5x rev in private transactions - your "assets" walk out the proverbial door every night.

There are other options outside of an earn out you can think about like revenue share after the company hits a minimum revenue threshold. Structured correctly with the correct protections it can work for both you and seller. I've seen it used effectively couple of times by quasi-state funds and by individual investors. Happy to discuss more if you want. redacted

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