Getting ready to sell your company in the next year? Or just finding out where you stand in case you decide to sell in the near future? In either case, it is important to understand how to negotiate earn-outs. They are extremely common these days — more than 90% of transactions I’ve worked on in the last two years have included an earn-out agreement. With this in mind, we’re going to share 5 tips to help you get the best possible terms and create a win-win for you and your buyer when finalizing your sale agreements.
Why Earn-Outs are Popular
An earn-out can be a great tool to bridge the gap between what the seller wants to be paid, and what the buyer deems the company is worth.
- Earn-outs give the seller an opportunity to prove their future worth
- Earn-outs give the buyer a sense of comfort that they are not overpaying for future revenue promises
TOP 5 Earn-Out Tips
After working on so many of these transactions in recent years, I have come up with a lot of tips regarding earn-outs. Today I’m going to share my top 5.
1. Realistic projections for future years: Earn-outs are based upon the future earning potential of the company and projections are the basis for most earn-out calculations. Now is not the time to produce hockey stick projections for the coming year, unless you can bank on it (literally)! It’s okay to be a little conservative on future growth as long as you build in an upside should you exceed it.
2. Keep it about top-line revenue: Gross sales are often the best metric for the seller when it comes to forecasting earning potential because gross sales are easy to measure and difficult to manipulate. The buyer however realizes that increased sales often come at the expense of gross margins. Some buyers also tie earn-out requirements to employees remaining after the sale, especially with companies who have a high amount of consulting as part of the revenue mix. They also frequently tie earn-outs to bringing a new product or service to market. Therefore, ideally, as a seller, you will want to negotiate your earn-out based upon top line revenue, but know that you will have to pass large discounts past the buyer first to keep everyone happy.
3. Term – 2 years and not more than 35%: The trend has been moving more towards two-year terms since 3 years is often too long sellers. Typically, in the past we have seen earn-outs range between 30% – 40% of the deal price, but that too has come down to just over 30%. If a buyer wants an earn-out beyond 2 years, build that extra time into a seller note instead.
4. No “cliff” or “all or nothing” earn-outs: To me, cliff earn-outs are those that are only achievable if a certain number (sales, gross profit margin, net income, etc.) are accomplished by a specified date. So, if you are just one dollar short of the number, you don’t get anything or drop off the cliff (my humor). This is never something you want to agree to as it is far too risky. Instead, negotiate multiple levels of earnout where you can step up your payout as revenue is attained.
5. Negotiate an upside: Let’s say that the earn-out is $3M for revenue above $5M at the end of 12 months. What happens if you hit it out of the park and actually generate $6M? If the earn-out is written that you earn just $3M when you hit the target of $5M in revenue, then there is no upside for you. I would suggest you go back to the buyer and propose a higher earn-out amount if you go over $6M.
This list only scratches the surface of potential earn-out arrangements. Learn more by downloading my free eBook for an in-depth look at each of these tips. The eBook also includes tips 6 through 10:
6. Keep the accounting separate if possible
7. Know the territory/customer base/consultants who will count toward your numbers
8. Who gets credit for upselling/cross-selling
9. Control of your existing revenue-producing employees
10. Monthly accountability and billed vs. collected
Download the eBook to learn more:
Top 10 Earn Out Tips: What to Know Before Engaging a Buyer for Your IT Business
Why Pay for an M&A Advisor if you Already Have a Buyer?