Purchase Price Contingencies (Earn-Outs)

Patrick J. Murphy

By Patrick J. Murphy

“In the business world, the rear view mirror is always clearer than the windshield” (Warren Buffet)

Private business owners, by and large, over estimate the value of their business.  Potential purchasers will not (and should not) ascribe the same sentimental value to the business that a founder would. 

A potential purchaser will base their purchasing decision on what is in the rear view mirror – – what are the historic financial results for the Company.  The potential purchaser’s lenders/investors will be like minded.

The current owner will have a firm grasp on how well the business has done in the past, but they tend to look out of the windshield more in terms of valuing their business with bright, optimistic expectations. 

In almost any sale, there is this friction between the Buyer and Seller of the value of the enterprise.  The Seller doesn’t want to lose the upside potential if they sell and the Buyer does not want to pay for unproven results. 

This friction is exasperated by poor economic conditions which causes the historical financial numbers to become skewed. 

EXAMPLE

Imagine that there are two similarly situated business owners who manufacture and sell the same product.  One of the owners (Sam) was age 65 in 1995 and the other was age 55 (Dianne) in 1995.  Both desire to retire at age 70.

In 1995 each of their business had sales of $10M and net income of $3M. Then year 2000 rolls around and Sam sells his business for $12M (which equates to four times the three year average net income) and retires comfortably.

Diane continues to operate her business throughout the ensuing decade with varied success due solely to the overall economic conditions.  From 2000 – 2007, her sales and net income figures remain strong, but starting in 2008, the Company’s sales decreased significantly as did the corresponding net income. 

  2007 2008 2009 2010
Sales $13M $8M $6M $7M
Net Income $3M $2M $1M 1.3M

 It is now 2010 and Dianne still desires to retire.  If Dianne sells her business using the same formula that Sam had used, the value of her Company would be approximately 5.73M.

So, Sam gets $12M when he sells his Company and Dianne only gets $5.73M?  Was the first one to ‘jump ship’ the winner?  Did Dianne sell too soon?  What are some alternatives that she could have considered?

PURCHASE PRICE CONTINGENCIES

A common technique used by owners of private enterprises to alleviate the inherent friction between the Buyer and Seller based on past versus future operational results is the use of a purchase price contingency. 

An earn-out is a purchase price contingency that can allow the Seller of a business to enjoy part of the up-side potential of a business.  Earn-outs can be based on any number of financial or performance benchmarks. 

For example, assume that Dianne agreed to sell her Company for a down payment of $5.7M, plus one-half of the Company’s net income for the next three calendar years in excess of $2.5M per year.

  2010 2011 2012 2013
Sales $7M $9M $12M $15M
Net Income $1.3M $2.8M $3.2M $6M

 The earn-out provision would provide the following payments to Dianne: 

  2011 2012 2013
Earn-out Payment $150,000 $350,000 $1,750,000

STRUCTURING THE CONTRACTUAL PROVISIONS

There are numerous contractual considerations that must be thought through when dealing with an earn-out. Carefully defining the benchmarks is a key to avoid post-closing disputes between the Buyer and Seller. 

In many earn-out situations, a group of key employees are retained as employees of the Company to assist in the growth of the operations.  Consideration should be given to what should happen if their employment with the Company is prematurely cut short.  An acceleration of the earn-out based on a liquidated formula would be possible, but that needs to be considered well in advance.

If the earn-out provision has benchmarks dealing with net income or Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), the Seller’s will want to be certain that certain caps are placed upon the Company’s ability incur additional expenses such as executive compensation that would negatively affect the earn-out payment. The Buyer will want to have a greater degree of flexibility in conducting the operations of the business and will not want undue constraints placed upon them. 

Some variations of an earn-out can avoid these potential disputes by using gross revenue as a benchmark, but using gross revenue can be risky for the Buyer as it will not necessarily correspond with available liquid assets to pay the earn-out payment. 

The more clearly defined the benchmarks you use are, the fewer disagreements there might be later between the Buyer and Seller when calculating the earn-out payments.

BOTTOM LINE

The use of an earn-out provision can be extremely useful to bridge the gap between the Buyer’s and Seller’s perceived value and can be instrumental in closing transactions that otherwise would not.  The contractual earn-out provisions should be meticulously structured to provide clear guidance for post-closing calculations and avoid timely and costly disagreements.


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