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Earn-outs in Connection with Selling Your Business

By Jeremy T. Waitzman, Partner
Walker Morton LLP

Often times there is a disconnect between the price a potential purchaser is willing to pay and the price a potential seller is willing to accept in connection with the sale of a business in Chicago.

Assume the following scenario: the sole shareholder of XYZ Company desires to sell XYZ Company for $5,000,000. The potential buyer is advised that XYZ Company is not worth more than $4,000,000. After much negotiation it is apparent that the potential buyer will not pay more than $4,000,000 based on XYZ Company’s current assets and performance, but would be willing to pay more if XYZ Company’s sales and profitability are maintained or increased after the sale.  Other than walking away, what alternatives are available to bridge the gap between the parties?

  • The parties could “split the difference” and agree to a compromised purchase price; or
  • The parties could consider structuring the transaction with an “earn-out”.

An “earn-out” is a vehicle used to provide flexibility in determining the ultimate purchase price for a business, payment terms or both. In our example, the parties could agree that $4,000,000 of the purchase price will be paid at closing and up to an additional $1,000,000 will be paid provided that XYZ Company maintains or increases its sales and/or profitability to certain levels over some designated period of time. If earned, the $1,000,000 might be structured as a one-time “balloon” payment or as a series of payments paid out over a certain period of time based on reaching milestones.

What’s in it for the buyer? The buyer receives several benefits from an earn-out. First, the buyer’s risk is reduced, as it likely has not committed to pay any more for the business than the business is worth at closing.  Second, if the buyer is required to pay additional amounts, it is likely that the company’s value has increased and buyer can typically utilize some of the revenues generated from the acquired company to make payments to the seller.  In such circumstance, buyer is typically able to defer payments to seller until some later date, and in any event, a date that occurs after the closing. Third, if the seller shareholder will remain with the company after the sale, the buyer has tied the seller shareholder to the future operations of the company independent of any employment agreement or a consulting agreement.  Since any earn-out is likely tied to company performance, the buyer has provided the seller with motivation to remain committed to the company and to work hard to maintain or increase sales and/or profitability for the respective earn-out period.  Since the buyer cannot “force” the seller to work for the company after the closing (even where the seller signs an employment agreement or consulting agreement), an earn-out may be an effective tool in maintaining the seller’s continued commitment, management and expertise for an agreed upon period of time. Buyer may also utilize the period during which the seller shareholder remains with the company to further learn the business, increase familiarity with the industry and enhance its own relationship with the company’s customers and suppliers.

What’s in it for the Seller?  Utilizing an earn-out structure provides seller the opportunity to receive more money than it otherwise would receive for the business.  In the above example, assuming the applicable criteria are met, seller would receive $5,000,000 for XYZ Company instead of $4,000,000. To agree to such structure, the seller must have great confidence in the future operations of the company as well as the buyer’s business plan, management skills and financial and other resources. Typically, the seller will not have unqualified confidence in the buyer or the future operations of the company and may seek some control over the continued operations of the company. Nevertheless, depending on buyer’s plans for the company, seller’s continued involvement may not be permitted and seller may need to rely on its comfort with buyer or seek additional safeguards in the form of negotiated controls regarding the earn-out formula.

Although an earn-out is a viable alternative in many circumstances, both the buyer and the seller must be very careful in structuring the earn-out. The seller cannot be given the power or discretion to operate the business to achieve short-term profits, while sacrificing long-term business objectives. Conversely, the buyer cannot be given the ability to increase expenses or divert sales, thereby reducing profitability, so as to defeat the intent of the earn-out. For example, by payment of large salaries and bonuses or making excessive capital expenditures, the buyer can substantially reduce or eliminate the profitability of the company.  Quite often, providing a very specific and detailed method of determining profitability alleviates the latter problem. The contract may also provide that if a dispute arises as to profitability (generally pre-tax), the determination of profitability will be made by an agreed upon independent firm of accountants and may include fee-shifting provisions for incorrect calculations or manipulation.

An earn-out may be an attractive alternative to consider when structuring and negotiating the sale and purchase of a business, but is not appropriate in all circumstances. When this method is used, it requires the coordinated input of the business people, attorneys, accountants and other professional advisors to formulate an earn-out, which is fair to all parties.

About the Jeremy Waitzman

Mr. Waitzman is Partner at Walker Morton, LLP and focuses on corporate transactions and business matters for privately held companies of all types and sizes. Mr. Waitzman regularly counsels on issues related to entity formation and structure, shareholder and operating agreements, partnership disputes, contract preparation and negotiation, mergers and acquisitions and other corporate dispositions. Mr. Waitzman routinely serves as outside general counsel, advising on issues of governance as well as day-to-day operations. Mr. Waitzman also possesses extensive experience with startups, having advised a myriad of enterprises facing early stage growth challenges.

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