Despite careful negotiation, disagreements are likely to emerge during a transaction. In the middle market, this friction is typically related to purchase price. One strategy to bridging the gap between buyer and the seller is to use an earn-out agreement. With a carefully crafted earn-out, the buyer makes additional payments to the seller, after the sale, based upon the performance of the business and the owner’s involvement in the business. These earn-outs are excellent tools closing deals when the buyer and seller are unable to agree upon a price. Implemented skillfully, they are designed to protect both parties and ensure that everyone receives fair value for the business.
Earn-outs seek to:
- Shorten the negotiation time.
- Get full value for your business.
- Ensure a seamless transition.
- Demonstrate confidence to the investor.
While exact terms vary, an estimated 25% of M&A transactions included an earn-out last year. The average length of the payout was one year, but 21% lasted longer than three years. Before committing to an earn-out, be certain the payment structure is desirable. It is important to consult with your advisor to ensure you are not overly confident about your price. Your advisor can also create a graded earn-out structure, making clear your payment is relative to actual performance, avoiding losing on your earn-out for just missing the target.