Getting ready to sell your company in 2021? 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 for 2021
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 earnout 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 he 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 earnout 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 earnout 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 earnout amount if you go over $6M.
This just scratches the surface of earn-out arrangements and all the possible iterations of them, but by focusing on these tips you will find yourself in a better position to create a win-win for you and your buyer.
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