A Portion of the Purchase Price for a Business,
Paid in the Future, Based Upon Milestones Achieved
I recently read a very informative article, written by Doug Robbins, president of Robbinex, Inc., about Earn-outs. Doug, whose company specializes in the sale of mid-sized privately held businesses, addressed these four important topics related to Earn-outs: (i) What is a milestone [when used to determine an Earn-out]?, (ii) What part of the purchase price [is appropriate for an Earn-out]?, (iii) How [is the earn-out] paid?, and (iv) When [is the earn-out] paid? Here’s an abbreviated version of this article, with a link to the entire article at the end.
As Doug states: “An Earn-out is simply defined as a portion of the purchase price of the sale of a business, paid in the future, but only if pre-agreed milestones are achieved after closing.
Usually, the milestone reflects something that the business is reasonably expected to achieve, within a predetermined time-frame. It could be a revenue milestone, a new client, a new product being released, a new process or technology being implemented that will reduce costs or increase revenues, the list goes on and on.
The portion of the purchase price allocated to the earn-out will depend on the significance of the milestone to be achieved and how the impact of achieving that milestone will affect the future profits of the business. To be candid the buyer doesn’t really care how much money the business made the previous year, or the years before, but rather how much he will make in the future. Remember that the true value of a business lies in its ability to earn a profit in the future, not how much it made last year.
Occasionally the milestone is such that the future profit adjustment will result in a pre-agreed amount of price adjustment and other times the future profit cannot be easily forecasted in which case the earn-out then becomes a formula.
A Seller must be comfortable that the Purchaser can in fact pay for a price increase, so often there is a question of what security ought to be in place to ensure the Seller is paid as agreed.
Reflecting over the foregoing, one can quickly conclude that earn-outs are complex agreements with countless variables and cannot be undertaken lightly. Anyone contemplating selling their business with an earn-out component needs to be surrounded by a competent team of advisors: An experienced M&A Lawyer; a Tax Specialist; an Accountant; an experienced Business Intermediary; and other specialists/experts with detailed operating knowledge to ensure the structure and terms of the earn-out meet the needs of the Seller. One must also be sure not to overlook the income tax treatment of an earn-out.
CASE STUDY 1: A recent client had begun the process of changing a significant supplier. The contracts were in place and the transition well underway. However, a health issue incentivized the client to sell his business earlier than he wished…
CASE STUDY 2: A recent Partnership needed to be concluded for a number of personal reasons. One of the Partners really didn’t want to sell, because he felt the business was about to grow significantly in both revenue and profit. He agreed to invest some of the proceeds of the sale of the Partnership into the Purchaser’s company, and to continue as managing director of the business he sold…
CASE STUDY 3: A letter of intent was successful negotiated in July of last year for an American firm to acquire a medium sized, profitable Canadian business with the transaction slated to be completed in September. A major contract was to be completed by the end of August which fit nicely with the completion of the transaction. The profits from that particular contract exceeded $250,000 and would belong to the Seller. However, the large contract was deferred for four months and the Seller wanted to delay closing until December 31…
CASE STUDY 4: A client’s husband had created a patented industrial product that he manufactured in a small facility near Toronto. Net earnings averaged $300,000 per year. One day he suffered a fatal heart attack and his wife took over the business…
To read the entire article prepared by Doug Robbins, founder and president of Robbinex, Inc., click HERE.
NOTE: The article also addresses 7 Earn-out variables, 3 common components of every Earn-out, and the completion of the Case Studies.
The Summit Acquisitions Group — Business Brokers and M&A Advisors — specializes in the sale, appraisal, and financing of privately owned companies ranging in valuation from $750,000 to $25,000,000. Contact their offices in Atlanta, GA or Charlotte, NC for a free consultation.