earn out provision
Art of the deal

Art of the Deal

Mitch Biggs is a Featured Business and Finance Contributor on Associated Content. This is a reprint of a previously published article.
 
Earn out provisions have a bad name in certain circles. However, used properly, earn out provisions can mean the difference between walking a qualified buyer and closing the deal. I will share some best practices for properly structuring earn out provisions. An earn out provision is a deal structure used during business transactions (selling businesses) that delays a portion of the payment to the seller for some period that is usually tied to a fundamental business metric. Earn out provisions are simple to structure but often difficult to execute. The key to earn out provisions is simplicity. They should be progressive in nature, meaning that the bonus structure is more lucrative the longer the owner stays with the company. Finally, earn out provisions should avoid profitability as a metric. Gross sales is the best earn out metric since the seller will no longer control expenses.

Typical earn out provisions are 1-5 years. There should be a base fee awarded to the seller tied to longevity and aggressive bonus tied to meeting or exceeding metrics.

Let us assume that after routine negotiations, there is a huge dispute between the buyer and seller regarding the selling price of a business. After further review, you discover that the root issue is disagreement over goodwill value of the business. The seller is aggressive and confident with the company sales growth forecast and willing to be retained as a consultant for the buyer during the transition. The gap on the agreed business value is $1.5 million dollars and neither party will budge. Offer an earn out provision.

Buyer pays $1.5 million less for the business and retains the seller under the earn out provision. The seller must meet sales growth targets for the next 2 years and will receive bonus payouts. The buyer agrees to pay the seller a base salary or retainer of $250,000 per year. Additionally, the buyer agrees to pay the seller a year end bonus for meeting sales targets. Year 1 the bonus is $500,000. Year 2 the bonus is $750,000.

The business has now been sold for $1.75 million over the price at closing while giving the seller the opportunity to focus on driving sales with a limited role in the new company structure. Seller receives $500,000 in base compensation for two years even if sales goals are missed. Finally, if year 1 targets are missed, the seller can recapture the entire bonus by delivering an exceptional year 2 result.

High margin businesses with strong cash flow are great candidates for earn out provisions. Lenders are interested in assets when financing deals. Earn out provisions can be an alternative to seller financing with the right buyer and seller circumstances.