Benefits and Drawbacks of an Earn-out in a Business Sale

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In today's difficult financial environment, the sale of a business often depends on the ability of the buyer to find creative financing. One of the solutions to financing the purchase of a business is an earn-out or earnout. If you are buying a business, you might want to include a discussion of a possible earn-out in your negotiations with the seller.

What an Earn-out Is and How It Is Calculated

An Earn-out (or Earnout) is a business purchase arrangement in which the seller finances the business and the seller's payment is based on the earnings of the business over a period of years. 

There are several ways to calculate an earn-out. In most cases, the business or the business assets are valued during the negotiation process, and a lump sum payout is determined. Then these payments are spread out over several years.

The payouts are then tied to the profits of the business, so if profits are high, the payouts are made more quickly. If profits are not as high, the payouts are lower and the loan takes longer to be paid off. 

For example, if a buyer and seller agree on the purchase price of a business as $750,000, the seller may agree to be paid back this price over a period of time, based on a percentage of the net profits/earnings of the business.

The seller may establish a minimum earnings percentage for each year or a minimum amount. The first year, the minimum might be 10% of net earnings before interest, taxes, depreciation, and amortization (EBITDA), and no less than $150,000. The second year, the minimum might be $200,000, and so forth. The principle is that the better the performance of the company, the faster the seller-financed loan is paid off. The principles of an earn-out are similar to seller financing in real estate. 

The Seller's Responsibility During an Earn-out

While the buyer has the responsibility to pay the seller, many earnout agreements require the seller to stay with the business or to provide consulting or other assistance during the earnout period.

Having the business owner participate with the business on a continuing basis has several benefits. It assures that the transition will be smooth, it gives the new owner the benefit of the previous owner's experience, and it gives the seller the ability to make sure the new business will survive - and thrive. 

The seller's responsibility and time period of involvement should be spelled out clearly and completely in the documents. A reasonable payment for work or consulting time should be provided to the seller during this time. 

The Benefits of Using an Earn-out for a Business Sale 

Earn-outs provide benefits to both the buyer and seller. From the buyer's point of view, the financing is spread out over a period of years, which makes it easier to pay for the business sale. Since the payback is tied to earnings, the buyer doesn't have to pay as much if earnings are not high. 

From the seller's point of view, the ability to spread out payments through several tax years helps minimize the tax impact of the sale (on capital gains tax). The seller also has an advantage in this type of arrangement, because the buyer has an incentive to do well in order to pay off the seller financing as soon as possible.

The Drawbacks to Using an Earn-out 

Earn-outs also have drawbacks for both buyer and seller. From the buyer's point of view, the seller is still tied to the business and may want to step in and "help out" if earnings are not high. The earn-out agreement should stipulate that the seller may not participate in the business after the transition period. 

From the seller's point of view, the obvious drawback is that earnings may not be high enough to pay back this financing quickly, or the buyer may go bankrupt. The earn-out agreement should include protections for the buyer in the form of minimums and maybe the ability to take back the business to avoid bankruptcy. 

Get Advice If You're Considering an Earn-out

Disclaimer: This article is a very brief description of how earn-out works. It's not intended to be tax or legal advice. If you are buying or selling a business and you are considering an earn-out, be sure to get advice from your financial advisor, tax advisor, and your attorney. An earn-out is a complex agreement and all the elements must be considered carefully.