If you’re new to business acquisition, you probably think that you’ve got to have the full funds in order to buy a business. Either through cash or finance, you need to be able to pay the full purchase fee in advance.
But this quite simply isn’t the case.
There are many ways to pay for a business – from traditional loans and cash to earn-outs and asset financing.
In this blog, we’re going to talk about a popular purchase method – earn-outs.
What Is An Earn-out?
In simple terms, an ‘earn-out’ is an additional payment that is agreed upon hitting certain levels of growth or business development KPIs (Key Performance Indicators). It is an amount ABOVE the agreed current value of the business, and payable only when the full agreed criteria are achieved.
It can be useful in certain circumstances, for example, if a seller feels the business is on the cusp of securing a major contract and can assist with securing it, but doesn’t want to wait the ‘x’ period of time before selling, then an earn-out can ensure that the seller is fairly compensated for securing that deal.
With an earn-out, a buyer and seller may agree on a proportion of the benefit to be returned to the seller in addition to the current agreed valuation, often to be paid out in instalments as certain criteria or milestones are met. As a buyer, you should only ever agree to a proportion of the uplift AND you must be sure you can pay the relative earn-out payments at the appropriate time.
What Is A Transitional Period?
A transitional period is present in any acquisition, regardless of the financing structure. It is the time during which the seller transfers ownership of the business to the buyer. During this time, key performance metrics and events will determine how effectively this handover has been completed.
It isn’t uncommon in acquisitions for the seller to remain involved for six months once they have sold the business. During this time you can use the current owner’s valuable insider knowledge to learn the ins and outs of your new company.
If this handover is not completed appropriately this may result in a reduction in the future payments due or the seller may need to be tied to an extended transitional services period.
Does it affect the earn-outs? Not necessarily. The earn-out payments are only affected if the seller fails to perform a related task/role in securing the additional benefit, or if the sale terms state that the right to an earn-out is reduced/removed should ‘other’ transitional elements fail to be delivered.
Types Of Earn-out
Traditionally there are two types of earn-out agreements in acquisitions…
Event-based earn-outs depend on specific criteria being fulfilled and forecasted for a set period. Events may include things such as…
- New contracts being introduced by the seller.
- Help with integrating new systems.
- Successful transfer of business relationships.
There may be one specific event, or many. With payments allocated proportionately to the assessed value it will bring to the business.
Financial Performance-Based Earn-outs
Financial performance-based earn-outs are payments based on meeting monetary expectations. You can cap the performance marker at any amount to ensure you do not end up out of pocket. It is usual to measure the performance of the following…
- Profit (measured as earnings before interest, taxes, depreciation and amortisation (EBITDA), or cash-flow.
- Gross profits.
For example, if the business makes revenue above a certain amount, known as a revenue hurdle, the seller will earn 10% of the profit.
The 5 Main Benefits Of An Earn-out
- The total amount you will pay is based on actual performance, rather than historical figures. If the business is not as successful as promised you will pay less, and vice versa.
- It may help to meet Seller expectations on the ultimate price of the business.
- You have longer to pay, which lessens the financial pressure on you to finance the acquisition all in one go.
- It can be tax efficient.
- The seller has an incentive to support the business in performing well, which is great for you as you get to grips with running your new company.
What Does An Earn-Out Agreement Include?
An earn-out agreement must be clear and concise to eliminate any misunderstanding, conflict or disagreements during the transitional period or an acquisition.
The key elements of an earn-out agreement are…
- The relevance of the transitional period.
- Measurement of future financial performance.
- The accounting method for tracking earnings.
- Staff retention and development within the company.
- Key Client development.
- Future revenue growth.
- Development of new technical or operational advancements
- The distribution of earnings and payouts.
It’s important to remember that an earn-out agreement is a complex document that contains all the details about the terms and conditions set out between the buyer and seller, and therefore it’s advisable to seek professional advice.
Is An Earn-out The Right Choice For You?
Earn-outs are a popular business financing agreement that can ensure that a buyer and seller get a good and fair deal. However, earn-outs are not suitable for every type of organisation. A lot depends on the financial needs and operational objectives of the business in question.
Thinking About Acquiring A Business?
With over 20 years of successful acquisition management, you can trust that Clive will use his expert knowledge, understanding and experience to assess whether an earn-out is the best option for your takeover. Click here to arrange a call back with Clive at a time that suits you.