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Would someone give me a typical example of an earn-out?

I know what it is but can you give me an example of how it would be put into action. Are payments typically quarterly, annual, other? How long should a seller expect to be in an earn out before receiving the rest of the money?

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Answers (9)
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Jun 1, 2017
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Monmouth County, NJ

will do , Ron

Sep 24, 2009
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Mark and others who answered, I appreciate the info. Mark, I would like more details on the businesses you worked those deals with. Please email me at roniacobucci@yahoo.com
Thank you!

Sep 23, 2009
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Mark, thanks for your examples on earn out. I would really appreciate more details on the first earn out you mentioned. It sounds like something I could use in a business I am considering in my neck of the woods in the SE. Please reply to musicmaakr@yahoo.com. Thanks!

Sep 22, 2009
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How to Buy a Business
WA

Mark, you are the Earn-out King. You have taken them further than anyone ever before.

Ron, I'll just elaborate a bit more on my second post below. What I have seen over the years is a situation where a business maintains a fairly steady performance which then begins to deteriorate for any number of reasons. It's more easily illustrated with numbers, so let's pretend that these are the ODCF for the last four years.

1,000,000 Year 1
1,100,000 Year 2
1,200,000 Year 3
800,000 Most current year

However, instead of accepting a price heavily influenced by the latest year's ODCF, the seller insists that it was an anomaly and demands that the selling price be based on the three previous years' ODCF only. He tells the buyer that the business will naturally bounce back to $1,200,000. After the sale it eventually does recover to that level but only because the new owner aggressively introduced new products, dropped dying ones, and went after additional markets. If he had merely followed the previous owner's strategy, the business would never have "bounced back."

In such a scenario, the seller shouldn't be rewarded via the earn-out because what he in fact sold was just an declining $800K business.

Sep 17, 2009
Doug Baumwall Licensed Business Intermediary
Collins & Collins Investments
Licensed Business Intermediary
Miami-Dade County, FL

Earn-outs can be an effective way to resolve differences of opinion regarding the amount of consideration to be paid for a business. They may protect buyers from overpaying, and sellers from ???leaving money on the table???. Both parties may use earn-outs to limit transaction risk. They are generally based on financial performance after the deal is closed such that the buyer agrees to pay the seller additional consideration pursuant to an agreed-upon formula. Sellers often prefer the formula to be based on gross sales, which are less likely to be negatively affected by a new owner. Buyers generally prefer the formula to be based on EBITDA so they will not pay for performance which doesn???t reach their bottom line. I believe earn-outs should be based on a very carefully defined gross profit. This compromise can be designed to address both points of view.

Buyers can use earn-outs to make their offer more attractive. Sellers can use earn-outs to obtain more consideration for their business while demonstrating faith in the value their company. Earn-outs can create a win-win that allows deals to get done by overcoming the spread between bid and asking prices, however they add complexity and risk if not structured and implemented properly. The concept is deceivingly simple, but documenting and executing an earn-out is far more difficult. Sellers will require audit rights and unrestricted access to financial reporting. Sellers are more likely to agree to an earn-out during the term of their employment by the new owner.

For example, if a new customer, new intellectual property, or a recent acquisition cause a spread between the bid and ask price, an earn-out could be based on the realization of additional gross profit derived from the new source. If the agreed value is $3 million and the discrepancy is $1 million, the deal could be structured with $2 million paid at closing, a fixed note for $1 million and a contingent note [earn-out] with a basket of $0 and a cap of $1 million. Specifically, let???s say the Seller is finalizing a $4 million contract to produce a new kind of widget for a new customer prior to closing. If the Buyer does not want to pay for an unproven income stream, an earn-out could be based on the amount of gross profit attributed to the new customer. The parties could agree that 33% of the gross profit from the new customer would be paid to the Seller during the 24 months following closing. Earn-outs can also be a great way of addressing the risk associated with customer concentration.

The earn-out clause must be clear and easy to understand. The formula must be very precise and use metrics which are easy to measure. It???s a good idea to include hypothetical examples to avoid potential disputes, and it???s important for the earn-out clause to address possibilities which may not be obvious at closing. For example, what happens to the earn-out when the business is sold again, prior to the end of the term of the earn-out?

Sep 17, 2009
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Monmouth County, NJ

Ron: I structured a few "earn outs" in my prior business and all is subject to negotiation. All of my earn outs were 100%, meaning there was no cash downpayment. I was taking over retiring peoples list of clients and business, which was just to risky to warrant any amount of cash upfront. Two examples:

Earn Out "A": Existing business was valued at $300,000.00. Earn out structured as 10% of GROSS paid monthly on a "Net 30", no caps and a 10 year term. So, if after 10 years, I only paid out $250,000.00 that was the end of the deal. Result: After 4 years, all of the persons clients whose business I took over ended up moving to other firms and were restricted as to who they can give business to. Therefore, all revenues dried up and I only ended up paying out I think around $75,000.00. Glad I did not put any cash up front.

Earn out "B" : Existing business was valued at $900,000.00 and I really wanted this business. I knew of the clients and their business I was going to possibly be assuming and I cut a deal with the seller where the base value was to be $1,000,000.00 ( So he was to receive another $100,000 as an incentive to do this deal with me ). Unlike "A", earn out was structured as 20% of NET Income paid monthly on a Net 30 basis with a yearly cap of $200,000.00. So if by October, we reached $200,000.00, no further payment was due until January of the following year. Bottom line: The gentleman received his million in a little over 7 years and I also thru in paying his health benefit premiums for the 1st five years of the deal which had a value of approximately $45,000.00 for him. This was a sweet heart deal. It worked very well for the retiree and it worked extremely well for me because my firm ended up continuing relationships with this guys clients list for quite a few years after the deal ended.

Again, everything is negotiable from monthly caps to yearly caps to final terms, etc.

Hope this helps,

Mark

Sep 17, 2009
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How to Buy a Business
WA

You also want to structure the earn-out so that you don't end up rewarding the seller for improvements that are due strictly to your business genius and hard work.

Sep 17, 2009
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How to Buy a Business
WA

Well, almost everything is negotiable. The term can be anywhere from a few months to two or three years. The payment schedule is negotiable. You also need to agree on the minimums and maximums to be paid out every period and in total.

Sep 17, 2009

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