Earn-Outs and how they impact the sale of a business

Matt Slappey CBI, BCI

By Matt Slappey CBI, BCI

Certified Business Intermediary; Mergers and Acquisitions (M&A) Advisor

Former GABB President Matt Slappey gave a presentation on earn-outs, what they are and how they can be used in the sale of a business. For those who missed this valuable presentation, the GABB gives you access to a recording of the speech and an outline of his PowerPoint presentation.

Earn-Out PowerPoint Presentation for the GABB

Earn-out:

Definition according to Google:

A provision written into some financial transactions whereby the seller of a business will receive additional payments based on the future performance of the business sold

Wikipedia defines it as:

Earn out refers to a pricing structure in mergers and acquisitions where the sellers must “earn” part of the purchase price based on the performance of the business following the acquisition. In an earn out, part of the purchase price is paid after closing based on the target company achieving certain financial goals

Reality of an Earn-out

An earn-out is used in most cases to bridge what a seller thinks his/her company is worth to the price that a buyer is putting on that same business.
When a business is full of “potential” that the owner has never actually realized (some of this is real and some is smoke)
Keeps negotiations alive when the parties seem far apart.

Scenario

You have a listing/engagement with a client.
The client has $500K per year in cash flow.
The market will tell you that a buyer’s offer of 3 x cash flow is not unreasonable.
The seller wants $2,000,000+ or a 4x+ multiple

Things to understand

Why does the seller think the company is worth more than the market rate?
Is there a valid reason that the company is worth more?
Is there true “unrealized potential”?
Is the company about to land a large contract or opportunity?

Examples of Companies that lean towards an “earn out.”

Consulting companies
No sales reps other than the owner
No management other than the owner
Family members involved in the business
Professional practices

SBA Deal?

If you are going to seek financing via an SBA loan for your deal, do not pursue an earn-out because the SBA does not allow the use of earn-outs. They require a defined purchase price.
This is not the SBA lenders in the room making the rule, it is the SBA.

Earn-out Structure

Create an earn-out that is the most simple and effective way to measure company or owner performance.
Complicated earn-outs must be clearly understood by all parties and all parties must be able to verify all the information required to create the payouts

Types of Structures

Revenue Goal
Gross Profit Goal
EBITDA or SDE Goal
Retention of current clients
Acquisition of new clients

Tax Implications

Most earn-outs are treated as an “Installment Payment” which allows taxation in the year it is actually received.
Can use this technique to keep taxation of sales of smaller businesses under the top tax rates.
It should also be noted that there may be situations in which a seller would choose to recognize the sale of a business currently and forego deferral treatment, such as when a business is sold at a loss, or when it is known or expected that tax rates will increase in the future.

Taking care of employees

It is possible for an owner to expense a portion of his earn out payments that are then paid to employees for retention or performance that leads to the seller receiving an earn-out payment. Scenarios change as to how to legally do this based on differences in an asset or stock deal, so consult a qualified attorney and/or tax advisor.

This can really motivate employees to achieve the earn out goals, thus earning it for the seller!

Summary:

Earn outs are a powerful tool to bridge the gap in business values.

Both sides can benefit from using them effectively.

There are tax implications and advantages of earn outs.

Knowing how to navigate earn-outs can help you close more transactions.

Questions?

Matt Slappey, 404-486-0350, mslappey@murphybusiness.com