When you put your business up for sale, you might receive offers that include terms for earn outs. Earn outs are a way for a buyer to defer or decline to pay for a portion of the business until after the sale of the business, when certain terms are met.
Why is the buyer asking for earn outs?
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Earn outs requests are common when a sale will take place before a key customer contract is made final. A buyer might offer earn outs that are contingent on the closing of the contract so they and the seller of the business can share in the risk of it falling through—or the reward of it materializing. |
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Earn outs requests also occur when a high-risk event in the business or market is imminent. Examples of these events could include a competitor planning to open a shop nearby or the introduction of technologies in your market that may reduce the need for your core product or service. Here, the buyer and seller may also agree to share in the risk. The buyer might agree to pay the seller a portion of sales or profits over time if the business can withstand the defined threat. |
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Earn outs can occur when buyers and sellers disagree about the past or projected performance of the business. Often, this is because of poor recordkeeping practices that make both assessments and forecasts difficult to complete. |
Buyers can arrange earn outs in several ways. Some offer a set percentage of gross sales, net sales, or net profits that are paid at defined intervals after the sale of the business. Others offer to pay the seller a portion of their earnings after a specific event occurs, such as the closing of an important customer contract or hitting a target sales volume.
How do earn outs benefit me?
When buyers believe a business is entering a period of high risk or making unprovable promises, most will either avoid making an offer or make an offer that's significantly lower than the asking price. Instead of allowing your listing to go stale or accepting a lower offer than your business deserves, you could agree to earn outs that'll help you recover the full asking price of your business when it meets the prescribed conditions.
The potential to receive your full asking price is one important benefit. Another is that you can structure earn outs to spread the proceeds of your sale across multiple tax years. By receiving small sums of proceeds rather than a single lump sum, you may be able to realize significant tax savings. Speak with a tax accountant to model how much you could save.
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Do I have any responsibilities to the business during the earn out period?
In some cases, yes. Some buyers may ask you to consult or work for the business until the terms of the earn out are met. Others prefer to run the business without the former owner's involvement. The buyer's attorney should draft an earn out agreement that spells out those requirements and the compensation you'll receive for any time you contribute to the business.
How long will it take to receive earn outs for the sale of my business?
It depends on the terms you established in your sales agreement. Instead of offering a timeline, many define conditions that need to be met in order to trigger the residual payout. But most often, buyers and sellers agree to terms that are achievable within three to five years.
Are there risks to earn outs?
Yes. The risks listed below are a few of the most common. But, with the help of a qualified attorney, you can mitigate many of them.
Risk 1: Earn outs may be designed around a complex set of variables that are difficult to attain.
How to mitigate it: Ask your attorney for help in negotiating an earn out that's centered on a single, easy-to-define metric rather than a series of goals.
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Risk 2: Earn outs may be designed in ways that are easy for a buyer to game. For instance, when the earn out metric is “profitability,” buyers could inflate the business's expenses or assign overhead that reduces the business's profitability to avoid paying the full value of the earn out or dodge the earn out altogether.
How to mitigate it: Your attorney can help you to minimize this risk by requiring mutually agreeable accounting terms to be used or metrics that are difficult to game as a condition for the sale. You can also require a third-party firm to be responsible for calculating the final value of the earn out after a prescribed period of time.
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Risk 3: The buyer may not operate the business as effectively as you would, which could either have a negative effect on the profitability of the business or prevent it from hitting easy-to-attain targets.
How to mitigate it: Your attorney can help you set stipulations to avoid this. They might specify that the business must be run in the same manner or grant you a say in changes that could significantly impact the performance of the business.
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Risk 4: Economic, health, or community crises could affect the business's performance and reduce your likelihood of receiving the full value of your earn out.
How to mitigate it: Ask your attorney to negotiate terms that will keep you from being penalized in years when disasters and unforeseen hardships impact its ability to achieve its targets.
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Risk 5: The buyer may sell the business before the terms of the earn outs can be met.
How to mitigate it: Your attorney can help you ensure that the earn out obligation endures after that sale and passes on to future owners of the business.
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Risk 6: The buyer may enter bankruptcy, which would inhibit their ability to provide the promised earn outs.
How to mitigate it: Your attorney can help you to push for a clause to buy back the business to help it avoid bankruptcy. This would provide you with the opportunity to stabilize the business's performance and sell it at a profit at a later date.
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Are there any best practices to keep in mind?
There are several strategies you can employ if you're considering an earn out offer for the sale of your business:
- Discuss the terms of earn outs with both your accountant and attorney. Be sure that you understand how much you could stand to gain—and how much is at stake for you to lose—through the offer.
- Recognize your right to counter any proposal to ensure you receive clear, fair terms and a fair price.
- Ensure that any offer including earn out provisions offers a graduated scale for payouts rather than an all-or-nothing option.
- Ask for metrics the new owner can't game (such as gross profits or retention of customers). Avoid manipulatable goals like revenue, net income, or EBITDA.
- Ensure that the buyer plans to run the business in the same manner that you did. This will help you ensure that the forecasts you established have a chance of being achieved.
- Ask for accommodation agreements that won't penalize you when natural or economic disasters keep the business from hitting its targets.
- Ask for an option to buy back the business to help it avoid bankruptcy.
- Ensure that the earn out agreement will survive any future sale of the business.
If I agree to earn outs, how will my broker be compensated?
Some sellers try to delay paying their broker's fees until they earn the full price of the business. This practice isn't fair for brokers who have no say in whether the earn out metrics are met. Instead, you should plan to pay your broker their cut of the amount you receive at closing and set up a trailing payment against any future earn outs you receive for the sale of your business.
Keep in mind that your broker's agreement likely states how deferred payments will be treated. Refer to your agreement to understand your obligation.
What's next?
Next, you'll need to prepare to assess and counter any offer you receive for your business. In this article, you can learn proven practices that'll help you negotiate a fair price and terms:
Selling your business is a complicated process, but we can help you with every action you need to take. Log into your owner's portal for free, personalized guidance that will help you succeed with your sale.
