Selling your business? Avoid the "Earn Out" at all costs...

[MJ DeMarco]

Thought this should be its own thread.

If you ever have a chance to sell your company and an "earn out" is part of the deal, TRY TO AVOID IT.

Negotiate something else in the deal -- cash, stock options, stocks, more equity, SOMETHING.

Over the years, I continue to hear horrible stories about earn-outs that fail, not because of the acquirees performance, but because of the acquirer.

The first sale I did had a fairly substantial earn out, which I earned none of because the acquisition company PIVOTED.

I think one of @Vigilante's business sales had an earn-out, and he reported a poor outcome as well.



If you're not familiar with what "earn outs" are, here is a ChatGPT definition:

--- AI START
An "earn out" is a contractual provision that is often included in mergers and acquisitions. It stipulates that the seller of a business must "earn" part of the purchase price based on the performance of the business following the acquisition.

In other words, an earn out is a way to bridge a valuation gap between a buyer and a seller. If the seller has optimistic expectations of the business's future performance, they may feel that the business is worth more than the buyer is willing to pay upfront. In this situation, an earn out can be used to pay additional money to the seller if the business achieves certain financial goals in the years following the acquisition.

The terms and conditions, including the period of time the earn out covers and the performance metrics, can vary widely and are subject to negotiation. Some of the most commonly used metrics include net income, gross revenue, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

While earn outs can facilitate agreements, they also come with risks. For example, if the business doesn't meet the agreed-upon targets, the seller might receive less than the initially expected value. Also, disputes can arise about the management of the business, as the buyer typically takes over operational control while the seller retains a financial interest. It's crucial for both parties to have clear agreements in the contract to mitigate potential disputes.
--- END AI

Do you have an earn-out story to share?

 

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[Kung Fu Steve]

My favorite words of all time... "I told you so!"

Only do an earnout if you want the business back... because you are going to get it back.

OR you're only going to get whatever the downpayment was...

It's too weird to do these deals. They sound SO good on paper. In real life, you've got to deal with humans.

 

[amp0193]

I turned down a deal that was $X "upfront" and more later.

The longer we talk, the more I realize my definition of upfront is today, and their definition was in 6 months (and then earn out and other bullshit from there).

If it was all upfront, I would've done it.


I'd be ok with an "earn out" as cherry on top that I could take it or leave it, if the total upfront amount was what I needed out of a deal. Last thing I want is a boss or a situation that I can't walk away from because I'm chasing a dangling carrot

 

[WJK]

Thought this should be its own thread.

If you ever have a chance to sell your company and an "earn out" is part of the deal, TRY TO AVOID IT.

Negotiate something else in the deal -- cash, stock options, stocks, more equity, SOMETHING.

Over the years, I continue to hear horrible stories about earn-outs that fail, not because of the acquirees performance, but because of the acquirer.

The first sale I did had a fairly substantial earn out, which I earned none of because the acquisition company PIVOTED.

I think one of @Vigilante's business sales had an earn-out, and he reported a poor outcome as well.

View attachment 49790

If you're not familiar with what "earn outs" are, here is a ChatGPT definition:

--- AI START
An "earn out" is a contractual provision that is often included in mergers and acquisitions. It stipulates that the seller of a business must "earn" part of the purchase price based on the performance of the business following the acquisition.

In other words, an earn out is a way to bridge a valuation gap between a buyer and a seller. If the seller has optimistic expectations of the business's future performance, they may feel that the business is worth more than the buyer is willing to pay upfront. In this situation, an earn out can be used to pay additional money to the seller if the business achieves certain financial goals in the years following the acquisition.

The terms and conditions, including the period of time the earn out covers and the performance metrics, can vary widely and are subject to negotiation. Some of the most commonly used metrics include net income, gross revenue, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

While earn outs can facilitate agreements, they also come with risks. For example, if the business doesn't meet the agreed-upon targets, the seller might receive less than the initially expected value. Also, disputes can arise about the management of the business, as the buyer typically takes over operational control while the seller retains a financial interest. It's crucial for both parties to have clear agreements in the contract to mitigate potential disputes.
--- END AI

Do you have an earn-out story to share?

I totally understand why this is a bad idea. Many years ago, my parents sold the mobile home park when they divorced and they carried the paper. Big mistake! I told Dad not to sell to that kid -- he was a loser. The buyer totally trashed the property and we had to take it back in terrible shape. That's how I ended up giving up my career and coming to Alaska to fix the problems.

 

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[GoldFibre]

In my full time job, we buy companies and this sometimes comes up. We propose an earn out only when the seller is basing his valuation on a hockey-stick projection that is divorced from past performance. So our proposition is 'we don't believe it will happen, but if you can prove it then you can have the money and it's win-win.'

But in practice the goal of the proposal is to get the seller more grounded in reality. Because if the hockey stick didn't happen when he owned 100%, why will it happen when he owns less of his company and thus has even less incentive? What will likely happen is that after a few months of trying, the former owner will realize he has no chance of getting his earn out, and then will blame the buyer for how they managed the company and restricted his entrepreneurial vision and it will turn into a lawsuit that only makes money for lawyers.

A better pay later mechanism is just a deferred payment, where the later payment can be discounted only if certain types of undisclosed liabilities are discovered after purchase. For example, maybe the owner had a lawsuit or an insurance claim against the company. At least where we are doing business this is a common issue and so we have to mitigate the risk.