Earn-Outs: Bridging the Valuation Gap

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Tonkon Torp LLP

Do we value our possessions more just because we own them? Sometimes. Does this association of value apply to businesses? Almost always.

The Cost of Risk

Buyers and sellers of a business often find themselves with a wide gap between what they are willing to pay and accept, respectively, for the business. Although many factors inform this difference, one of the primary contributors is the parties’ differing perspectives regarding the certainty of the business’s future financial performance.

Not surprisingly, sellers have a rosier perspective on future financial performance. This perspective is due in part to their historic connection to the business and drive to realize a lucrative exit. In addition, if a proposed sale falls through and the seller continues to operate the business, the business failing to achieve projected financial outcomes is less material. Although a business owner would certainly prefer for their business’s financial performance to continuously improve, owners may still realize a profit even if the business fails to grow or suffers a dip in its financial performance.

For a buyer, the risk from the business’s future financial performance is much higher. Almost all buyers rely on debt to finance some portion of the purchase price for a business. If the business underperforms, not only will it take longer for the buyer to realize a return on its investment, but the buyer may need to infuse additional capital into the business to maintain working capital and cover debt service.

Bridging the Valuation Gap

Creative deal-makers leverage different tools to bridge the value gap between buyer and seller expectations. One of the most common is an earn-out, which, in a given year, is used in 20% to 33% percent of all private company acquisitions.

An earn-out is a mechanism by which a portion of the purchase price for a business is calculated and paid after the closing of the sale. Whether an earn-out will be paid, and sometimes the amount to be paid, is determined based on the business’s performance after the closing. The metrics for earning an earn-out tend to be focused on the business’s post-closing financial performance, including realizing a minimum EBITDA or exceeding minimum revenue thresholds in the year or two following the closing of the acquisition. However, the conditions to earning the earn-out may be more focused on operational targets, such as retaining or growing the business’s customer base or key projects realizing projected outcomes.

The primary benefit of an earn-out to the buyer is sharing with the seller the risk of the business’s future performance. An additional benefit is delaying the payment of a portion of the purchase price. The buyer not only pays less cash at closing, but also may be able to finance the payment of some or all of the earn-out with revenue realized from the business’s post-closing operations. A buyer may also leverage an earn-out to motivate selling owners to contribute to the business’s continued growth and success by achieving the milestones required for payment of the earn-out.

Exchanging Today’s Value Disagreement for a Future Lawsuit

Although earn-outs can facilitate resolving valuation disagreements, they provide fertile grounds for disputes. Even if the selling owners continue working for the business after closing, the business will be under the buyer’s ownership and control. Notwithstanding the purported alignment that an earn-out gives the parties with respect to the business’s future success, the buyer has a financial incentive to develop creative ways to avoid paying the earn-out.

No different than other aspects of a purchase agreement, provisions governing an earn-out should be specific and clear to minimize the potential for disagreements. The more general and vague the terms of an earn-out, the more likely it is that the parties are simply trading today’s value disagreement for a future lawsuit to determine whether an earn-out was earned.

Read our articles on rollover equity and understanding a buyer’s expectations for a post-closing engagement for more information. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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