Using Earn-outs to Structure Business Sales Agreements
Buying and selling businesses is an integral part of the economy. Placing a realistic value on a business is a material part of a buy-sell transaction. However, valuing a business — especially a closely held one — can be challenging. Buyers and sellers often have vastly different appraisals of the business’s value. Buyers are purchasing the company based on its present ability to generate revenue and profits while sellers may focus on its projected ability to improve its performance in the future. It is very difficult to put a value on anticipated results, since future performance is never assured. Because of this uncertainty, the parties will often utilize an “earn-out” to structure the transaction.
An earn-out is an arrangement in which the seller is contractually obligated to stay involved in the business for a period of time after the close of the sale. The seller uses its continuing goodwill with customers to help the business grow and prosper. In exchange for meeting pre-negotiated performance targets, the seller receives additional monies for the purchase of the business. This arrangement can bring accountability to the valuations of the business made by both sides.
Earn-out agreements usually last for a period of years. Since the seller is compensated based on measurable results, neither party should feel slighted after periodic evaluations. The buyer also gets the advantage of being able to spread out some of the purchase price of the business over time. Because earn-out payments are made only when the performance targets are met, the buyer pays a portion of the total price over a period of months or years. Also, if financial results improve as expected based on the negotiated targets, the business should be in a better financial position to make the payments.
Despite those advantages, there are risks in using earn-outs. Things can get complicated when the former owner stays on board, especially in a smaller company. A seller could forget that he or she is no longer the owner and might overstep their authority, leading to confrontations and costly mistakes. Also, the seller might be notching up business operations to maximize performance only during the earn-out period, and they can decline sharply once the seller is gone. The company also might suffer from policies or efforts that are less than ideal for the longer term. Avoiding these pitfalls requires that earn-outs be thoroughly and carefully negotiated and monitored. Anyone involved in the purchase and sale of a business should have the benefit of competent and diligent business attorney to represent their interests.
Based in Plano, Texas, the Law Offices of Kevan I. Benkowitz has a full-service business and commercial transaction practice. If you want to start, grow and protect your company, our firm can provide guidance aimed at helping you reach your optimal goals. Feel free to contact us or call 972-464-2645 for an initial consultation.