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Earn Out

Tags: buying a business, deal structures, financing, selling a business

Comments & Replies: 2     Views:     Post ID:     Comments About This Glossary Term

Four caveats about an "earn out" provision:

1. Get the advice of a CPA.

2. Get the advice of a business-savvy attorney, and have him or her draft the intricate and explicit language required.

3. Make the "earn out" based on something specific and concrete. For example, "gross revenue" rather than "net profit." -- The reasons are obvious.

4. Secure the payout with the personal guarantee of the new business owner, and a security interest in tangible easily-liquidated assets of the new owner.

When negotiating for purchase of a business, what happens if the buyer and seller want to strike a deal, but face an obstacle such as the buyer not having the resources to meet the seller's terms? Or if the two parties are unable to agree on a selling price? Occasionally, these deal-killing problems can be overcome if buyer and seller are highly motivated to achieve a transaction. One possible solution is called the earn-out.

The basic purpose of the earn-out is to enable the buyer to begin taking over the business after paying an agreed-on sum to the seller, then make additional payments over a specified period of time. If the buyer is short of funds or borrowing power to assume full ownership when the escrow is completed, he or she will 'earn' a progressively larger interest in the business, with the continued payments to the seller, until the full price is paid and the buyer becomes 100% owner. The earn-out also is a popular strategy when the two parties cannot agree on the 'fair' price. That may happen because the seller's figure is based on the company's anticipated future earnings, while the buyer wants to pay a price based on historical performance. The earn-out agreement includes a mechanism for adjusting the price upward if the company's earnings increase over time. The price increase will be reflected in larger payments from buyer to seller. The contract might also call for the price to adjust downward if earnings decline, with purchaser lowering the payment on the obligation to the seller.

There is potential for misunderstandings with an earn-out approach to a business sale. It is meant to anticipate various scenarios in the future and it comes with the risks of disagreements and misunderstandings later on. That's why the successful earn-out contract incorporates a clearly-described formula to detail the terms by which the buyer will take over progressive interest in the business. For example, what portions of the business will the buyer receive in return for what level of financial compensation paid to the seller? And what is to happen if the buyer should become unable to meet the stated obligations to the seller? These possibilities definitely need to be addressed in the contract to minimize the likelihood of problems between buyer and seller after close of escrow.

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