Are you planning to sell your business? There are many things to consider before selling a business. Learn about these aspects so you can negotiate better and get the best deal. A prospective buyer may offer the earn out business sale payout option. What is selling a business the earn out option and how does it work? What are the advantages and disadvantages if you choose this payment option? This guide will help you understand this payout option and take the right decision.
What Is an Earn Out?
It is a provision placed in the business sales contract. This provision states that the business seller will keep receiving an agreed amount regularly up to the specified time limit or until a specified payment milestone is achieved. This payment is dependent on the business achieving certain financial goals.
The earn out option is used when the buyer does not want to pay the agreed amount in full immediately after buying the business. The buyer chooses this payout option whereas a fixed amount of the sales price is paid upfront while the remaining amount is paid through the regular earn out payments. The recurring payments are based on several factors as agreed by both the buyer and the seller.
Business buyers use this option to ensure the business they buy will continue to perform well.
Things to Know for the Business Seller
The buyer pays the seller the earn out amount only after the specified financial or performance goals are achieved.
This option is mainly used when the buyer does not agree with the seller’s valuation of the business. It can be due to other reasons as well. For example, a buyer may want the seller to remain associated with the business for some time to prevent disturbing the current performance of the business. It can be due to the buyer’s inability to pay the full asking price at one go. The buyer may have doubt about the valuation, performance data, cash flow and other records, and wants some level of guarantee from the seller.
The uncertainty associated with the buying of a business is reduced considerably with the earn out option. The buyer gets some level of assurance when the earlier owner remains invested in the business.
The earn out is preferred by the private-equity investors. It becomes more common when the market is down and uncertain. This payout is suitable for all types and levels of businesses.
If you choose this option, make sure you get some guarantee the business will be managed and operated professionally and according to your terms. At least, it should be managed as it is being done at the time of its sale.
Check the buyer’s record in running such a business. You should be more careful if the entrepreneur does not have any experience or expertise in running such a business. In such a case, it is not wise to choose a payout option based on the projected performance of the business.
No buyer buys a business to incur losses. They always buy a running business when they expect to earn the same or higher profit than what it is earning. However, you should assess all aspects of the business sale contract and take a close look at the terms and conditions before choosing this payment option.
If you need help in this matter, consult a business sale or M&A consultant to learn more. The consultant will assess all your business records and take into account your expectations. You will receive professional guidance that will help you take the right decision about the earn out option.
The Formula Used to Determine the Earn Out Payment
The formula for the earn out can be based on anything acceptable to both the seller and the buyer. Common options include EBIT, EBITDA, adjusted EBITDA, gross profit margin, gross revenue, gross revenue growth rate, employee retention rate, and gross revenue for each full-time employee, among others.
You should try to limit the duration of payout to the minimum years possible, especially when a larger share of the purchase price will be paid through the earn out. This option is used to pay almost 10-50% of the sales price and generally takes place over 3-5 year period.
Limit your exposure to the risks by choosing the terms suitable to you and over which you have some control. Otherwise, the buyer and even other parties can dictate the earn out details. For example, unless you remain in control of the management, it may not be wise to tie your earn out payment with the business’s profitability.
Both the buyer and seller face some risks in this type of contract. A buyer can purposefully mismanage the business to miss the performance target and avoid paying the compensation due to the seller. On the other side, a seller can overstate revenue or understate expenses to ensure the payout.
Use a formula that is tied to a fixed metric or measurement. Choose the contract term where you will remain in control of the business until all your payments have been cleared by the new owner.
Both parties must have a clear understanding of the cash flow and business operations. The earn out payout option can help you sell your business faster if you are finding it difficult to sell it at your asking price.
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