How to handle an earn-out
Before going ahead with this type of business-exit agreement, here are five things you need to consider
When selling a business, earn-outs are a common structure agreed between buyer and seller to – in theory – ensure a smooth transition between owners.
With an earn-out, an owner (and sometimes other key personnel) will agree to stay involved with the company for a defined period after the sale in return for a higher valuation for the business.
While entrepreneurs often find these agreements can be an effective way of moving on from their company while maximising returns, there are also several problems you might encounter.
Here are five things to keep in mind when considering an earn-out.
1. Work on the structure
The most important part of an earn-out is to create a structure you are comfortable with, so work with us to build something that suits you and your future plans before discussing with the buyer.
A typical deal might see 60% of the agreed sale price paid on day one, with a further 20% the year after and the remaining 20% after two years. Some of the subsequent payments are likely to be related to the performance of the business.
This is increasingly the case with the uncertainty created by the pandemic.
When negotiating the structure of an earn-out, it is vital to ensure that the initial payment is enough to set you up for whatever you plan to do next, whether that’s retire, start another business, secure your family’s future or just pay off your mortgage. The other payments can improve your circumstances but should never be taken as certain future income.
“The first payment is the one that’s guaranteed, so you want it to be above your threshold of acceptability,” says Martin Brown, our Chief Executive Officer. “The other payments may happen, but it’s often a case of ‘jam tomorrow’: sometimes they won’t.”
2. Don’t expect a smooth run
One of the most common reasons for an earn-out not working as planned is that the previous owner fails to adapt to working under a new regime when they are not in charge. In other words, entrepreneurs often struggle to become employees. This feeling is exacerbated if the owner has received a life-changing amount of money in the initial payment of an earn-out. Under such circumstances, you might decide there are more important things in life than clocking in for work every day – such as health, family and travel.
However, if you get on well with the buyer and enjoy remaining involved in the business you built, earn-outs can be an excellent way to maximise the gains from a sale.
“Earn-outs are dangerous if you are desperate for those payments to be made to you,” says Andrew Lock, Co-founder and Director of LockDutton Corporate Finance. “They work if you get enough money on day one, you like working in the business and you’re happy to continue to work so that the earn-outs can be paid. Otherwise, it’s better to structure any subsequent payments as deferred payments, which is money that will be paid irrespective of the subsequent performance of the business you have sold.”
3. Consider a partial exit
A potential alternative to an earn-out is a partial sale. Under such an agreement, a buyer might acquire 35% of the business, leaving the owner in control but also able to take some money off the table. This option can work if there is the right chemistry between buyer and seller because it can allow the owner to gain some financial security but also leave them hungry enough to continue growing the business.
Another variation on an earn-out is a management buyout, where the owner sells to the existing management and agrees to stay on for a defined period. This can have the effect of maintaining the owner’s interest during the earn-out because the management team was in place before the sale and are more invested in the company than an unknown buyer might be.
“You then get a situation where the management team really is working for the previous owner because they’ve already invested in those guys and want to see them do well,” says LockDutton Corporate Finance Co-founder and Director Craig Hewitt-Dutton.
4. Things will get stressful
As with any deal, the closer you get to completion, the more pressure there’s likely to be on you, the seller, to make key decisions.
“It is a stressful process,” says Andrew. “You are running your business every day, which you can’t let drop off while also being involved in the transaction. It’s a tough time.”
This is particularly true with an earn-out because you will go through the entire process, which often lasts nine months or more, only to return to work under the terms of the agreement.
“The emotional challenges of a sale process mean that once you get to the other side, everyone feels like they have given everything,” says Martin. “It’s difficult to then feel you want to start working again. It has a real impact on people.”
5. Seek advice
Most entrepreneurs will only sell their business once, so it’s vital to work with advisers who have the experience to guide you through the process. Talk to us before you make any decisions.