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How To Sell While Capturing The Value Of A Growing Business

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In a recent article regarding the benefits of seller financing, I noted that the most significant benefit of seller financing was the ability to maximize the sale price of a business. An “earn-out” is a special type of seller financing that has become more common in recent years as a part of small and mid-size business acquisitions and can be an excellent strategy under the right conditions. An earn-out is particularly suited to enable a business owner to sell while retaining the ability to realize the full value of a growing business.

 

An earn-out is basically a contingent payment based on the future performance of a business. The fundamental concept behind an earn-out is the sharing of risk/benefit between a buyer and seller. Under the right circumstances, an earn-out aligns the incentives of the buyer and seller such that both will benefit if the business prospers. At its core, an earn-out is another form of profit sharing based on the mantra, “The more money I make, the more money you make.”

 

Although there are many ways to structure an earn-out, it is commonly structured so that the seller receives a percentage of some financial measurement such as sales, gross profit,  net income or some combination thereof. For example, an earn-out might be structured such that the seller receives 6% of gross profit on a monthly, quarterly or annual basis for some period of time, typically 3-5 years. The upside to an earn-out is that the better the financial performance of the company, the higher the seller’s earn-out compensation. On the downside, poor results can mean little or no additional compensation.

 

Earn-outs can be a great strategy when; 1) there is a significant gap between the buyer and sellers opinion of value, 2) the prospects for future growth are strong, and/or 3) the seller will be retained as a shareholder, employee or consultant with the ability to influence the future performance of the business. Often, business owners feel the potential of a business has not been realized for some reason and/or the business is about to experience significant growth. Unfortunately, a buyer will not pay a seller for potential or expectations. However, a reasonable buyer should be willing to include an earn-out as part of the overall compensation for the business wherein the seller can realize fair compensation should the business in fact grow and prosper as a result of the efforts of the previous owner.

 

In my opinion, the ideal situation for an earn-out is when the selling owner is confident of the company’s future prospects, comfortable with the buyers competence and will stay with the company as a manager for some period of time after the acquisition. In this situation, the selling owner can have a major influence on maintaining customer relationships, employee relationships and the future success of the business which translates to increased earn-out payments and perhaps more income than could have been received using only cash and conventional financing approaches. One of the main benefits of an earn-out is the ability to realize the full value of a business that is growing.

 

Earn-outs must be carefully developed so that the metric used to determine the earn-out value and payment is transparent and can not be unfairly manipulated by either party. For example, an earn-out based strictly on sales by the seller could potentially be adverse to the buyer if higher sales are achieved through discounted prices resulting in a net loss. Conversely, an earn-out based strictly on unadjusted net income can be unfairly manipulated by the buyer to include excess compensation or discretionary expenses that artificially lower net income. Properly structured, these scenarios can be addressed through carefully developed language in the earn-out agreement.

 

Of course, with any seller financing approach, there is risk that the earn-out could turn out to be worth very little or nothing. However, the beauty of an earn-out, properly structured, is that the buyer is just as motivated as the seller to be successful and the seller has the potential to make more money than a valuation based solely on the past performance of the business, particularly in the case of a growing business.