Earn Out Provisions: Are You Using All the Tools Available to Close Business Transactions?

It is important to use all tools available when selling businesses? How comfortable are you with the earn out provision? Earn out provisions have a bad name in certain circles. However, used properly, earn out provisions can mean the difference between walking a qualified buyer and closing the deal.

An earn out provision is a deal structure used during business transactions (selling businesses) that delays a portion of the payment to the seller for some period that is usually tied to a fundamental business metric.

First, why the bad reputation of earn out provisions? I fault the Business Broker community. Greed kills deals. Most business brokers are too worried about their commission and steer clear of earn out provisions when discussing terms with buyers and sellers. Earn out provisions are simple to structure but very difficult to execute. A properly written listing agreement will cover business brokers commission with earn out provisions. That's a great topic for another article!

What businesses are great candidates for earn out provisions? Typically the earn out provision is a great solution when there is considerable goodwill baked into the selling price, low asset and high cash-flow businesses that are experiencing growth and when businesses have had good growth followed by a poor year due to external economic forces with aggressive growth forecasts.

Seller advantages and disadvantages using earn out provisions. The seller can start their clock ticking on their exit strategy for the business and take the business off the market. There will be full disclosure with employees about transfer of control rumors and a smooth transition with the new ownership. The disadvantage is they get part of the value at closing and then must deliver the terms of the earn out provision to be paid the balance of the business value without being the boss.

Buyer advantages and disadvantages using earn out provisions. The buyer is able to feel comfortable with the agreed upon price that is usually more in-line with company assets lenders love for financing. Any quibbling over the anticipated growth of the company is left on the seller's shoulders to deliver as part of the earn out provision. One disadvantage of earn out provisions for buyers is that they are limited as to what they can do with the company during the earn out period. The seller must retain enough interest to meet the demands of the earn out provision.