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Fact & Fiction About “Earn Out" Provisions When Selling Your Business

by on
in The Business of Business Finance

Most of what you’ll read about “earn outs” warns of entrepreneurs being cheated out of significant parts of their company value because of unrealistic financial hurdles or accounting treatment that benefits the buyer rather than the seller. While there are many stories of disappointed company sellers, properly designed “earn outs” can be a very effective tool to help close a deal and reward entrepreneurs for the future value they create within their new enterprise.

I am currently working to finalize two deals where earn out provision will play a critical roll in a successful transaction for both buyer and seller.

The first is a government IT services firm with revenues that have leveled off at about $6.5 million over the past 3 years. Because of new contracts, they’re 2011 revenue will likely exceed $9 million. For personal reasons the owner (my client) wants to sell now and still be compensated for this future revenue, which is not guaranteed, but is “highly likely.”

This situation is tailor made for an earn out provision. It allows for a transaction now — based on current revenues — and accommodates for future upside created by the seller IF those additional revenues are actually realized. It works well for the seller who can also benefit from larger revenue numbers while eliminating current risk and allows the buyer to make a strategic acquisition while limiting their down side exposure.

The second client is a medical technology firm with growing sales numbers, but is struggling to grow their sales rapidly due to an extended sales cycle. Their potential acquirer has the ability to significantly shorten this sales cycle and introduce them to new business based on their existing relationships.

In this case, revenues could actually double in 12-18 months due to the impact of the combined companies (it’s a great strategic fit). Because of this opportunity, the seller wants to be compensated for large revenue growth which will only be realized after the acquisition.

The best solution is a company sale based on current revenues with an earn out that allows for future compensation based on increased sales targets. This creates a win for the seller because their earn out could grow to become a significant part of the final purchase price yet they will still realize much of the current value of their company.

Again, the buyer is in a position to make a strategic acquisition and minimize their risk by sharing is the future upside of the combined companies.

Both of these examples illustrate how an earn out can be an effective tool when selling your company. The key, however, is negotiating terms that are easily monitored, clear and understood by both parties and also protect your interests. The best way to insure your “earn out” is successful is to structure a deal from the beginning that creates a win-win for both parties.

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