In a typical negotiation over sales price when selling your company, the Buyer will often try to base the price on historical performance to minimize the value and the Seller will often try to base the price on projected performance to maximize the value. The Buyer’s argument is that they can’t pay for what hasn’t been achieved and the Seller’s argument is that the company is perfectly postured for accelerated growth, so the value necessarily includes future performance. One tried and true method to bridge the gap is by fixing a set purchase price based on historical value and designing an Earn-Out that allows the seller to maximize value by hitting its projections post-sale. For example, if a company has Gross Revenue of $50M and Earnings before Interest, Taxes, Depreciation, and Amortization (commonly referred to as EBITDA) of $5M for the twelve months before the sale, but is projected to have Gross Revenue of $60M and EBITDA of $6M for the twelve month period after the sale and the market dictates a 7 times EBITDA multiple for valuation, the Buyer will likely argue the company is worth $35M and the Seller will likely argue the company is worth $42M. If the parties simply negotiate a number in between the two, the Seller may be leaving money on the table, or the Buyer may be overpaying depending on how the following year turns out. In this situation a Win-Win result may be for the Buyer to pay a fixed $35M plus provide the potential for the Seller to earn an additional $7M by hitting its projection. The $7M conditional portion of the purchase price is referred to as an “Earn Out.”

Unfortunately, consistent with everything else in the law, it is never that simple. Structuring how the Earn Out will work can be very complex and convoluted as well. From the Seller’s standpoint, they typically would like it to be as simple as receiving a pro-rata portion of the $7M based on the actual Gross Revenue over the next twelve months in excess of $35M, so if Gross Revenue actually comes in at $38.5M, the Seller will earn $3.5M of the Earn Out. The Buyer on the other hand will likely want the Earn Out to be based on EBITDA and may only want to pay any portion of the Earn Out if the full EBITDA target is hit or may want it to be based on incrementally achieving portions as opposed to a sliding scale. Where EBITDA is probably the fairest measure since the Seller has no control over expenses, accounting methods, etc. post-closing, you must be very careful to negotiate caps on expenses, hiring limits, management fee structures, allocation of corporate overhead as well as the use of consistent accounting principles. As you can imagine, even though the Buyer will likely want to use EBITDA, the Buyer will not want the Seller to have much, if any, say in post-closing operations, so this becomes a very sensitive negotiation. Accordingly, if you use an EBITDA structure, one thing to consider is negotiating EBITDA adjustments versus hard caps. This way, the Buyer can operate its business in any manner it likes, but the Seller’s ability to earn the Earn Out is only impacted by the agreed upon limits. Other major concerns to consider are how the sold business is going to be integrated with existing operations of the Buyer, what happens if the business is sold prior to the end of the Earn Out period and what limitations the Buyer’s lender may have in its loan documents on its ability to pay the Earn Out.

As you can see, using an Earn Out model can be a great way to bridge a valuation gap, but you need to be very cautious in how you structure the Earn Out, so you actually get the benefit of your bargain.