Mergers and acquisitions (M&A) can be risky transactions for any and all parties involved, but the buyers of a business obviously carry the brunt of the risk. These deals can be particularly tricky when the targeted firm is a fledgling startup or relatively new to the pertinent industry. As a result, seasoned M&A professionals have created various ways to mitigate some of the risks associated with these sorts of deals to entice firms to continue buying up smaller enterprises and to induce business owners to commit to a sale. One example of a risk-allocation tool that is now used with relative frequency is the earn-out. Here is a quick rundown on what this is and how it works:
What they are
In a nutshell, when an earn-out is included in the terms of an M&A deal, it allows for a certain percentage of the agreed upon sales price to be deferred until a later time. In general, the selected percentage of the sales price will be related to the performance of the targeted business subsequent to the closing of the merger or acquisition. Basically, the sellers of a business will earn more money for selling their company if and when certain financial metrics are met.
Why they are used
The earn-out may appear unfair at first, especially from a seller’s perspective, and one might wonder why anyone would agree to relinquishing ownership but receiving money for doing so at a later date. The reason that the earn-out is used is because it offers a middle ground between the seller of a business and the buyer. Sellers always want to ensure that they are selling as high as possible, but buyers may not be completely confident that the business is worth what it seems. Thus, by agreeing to defer a portion of the purchase price, the business is afforded an opportunity to perform in a manner that demonstrates its worth. This obviously makes the buyer of the business feel more comfortable and ensures that the seller is compensated fairly when the time is right.
How they may be helpful
Incorporating an earn-out into the terms of a transaction can be helpful in various ways. For one thing, it often serves as a buffer with respect to valuation, as the buyer is not obligated to render a part of the purchase price until the business has really proven itself and its alleged valuation. In addition, buyers may not have the financing available at the time that it makes sense to close the deal, and thus the deferred payment allows time to locate and/or earn that capital, in some cases through the profits of the very business being purchased. Of course, using an earn-out is particularly useful when the targeted business is a startup or does not have a significant financial history available to make accurate forecasts and projections.
How they may be a hindrance
Depending on the stage of a business’s existence, offering an earn-out rather than a straight pay out may end up being a deterrent for sellers. It may be seen as a slight or an indication that the purchasers are not serious. In addition, although this measure affords the buyer of the business a fair amount of risk protection, there is always the chance that the business will not meet the agreed upon objectives, in which case the seller may be left out in the cold.
As with many sales terms, there are advantages and disadvantages to agreeing to an earn-out, and it is critical to consider carefully whether it makes sense for the deal at hand.