Many times, in middle market transactions, buyer and seller do not agree on the purchase price. One way to bridge the valuation gap between buyer and seller is to structure an earn-out. An earn-out is a payment plan in which the buyer will make additional payments to the seller based upon the performance of the newly acquired business. Earn-outs can be essential to closing M&A transactions in which the buyer and seller cannot agree on the value. Earn-outs are designed to ensure that each party receives fair value as a result of the transaction.
There are several advantages to structuring an earn-out. Earn-outs can reduce negotiation time in cases where neither buyer nor seller can agree on a valuation. An earn-out can help the selling party receive the full value for their business by the seller making specific payments, over time, based on the seller achieving specific performance criteria. Through the use of an earn-out, the selling company may receive more money (or shares) than they would have if the acquisition were a one-time payment at closing. Buyers like the use of earn-outs because it reduces the risk of overpaying for an investment that does not achieve its financial projections. Because of this risk mitigation for both buyer and seller, earn-outs are oftentimes used as a way to make a fair compromise on the purchase price of the target company.
Experienced M&A advisers can help structure and negotiate an earn-out that will be acceptable to both buyer and seller. A well-structured earn-out can be beneficial to all parties involved. The buyer feels confident they are not overpaying for the company because the seller has to achieve certain performance thresholds in order to receive additional payments. The seller is satisfied because additional consideration will be paid if the business does achieve its forecasts. The earn-out has the added benefit of demonstrating to the buyer that the seller believes in the forecasts and that the seller is not in a hurry to exit the business. (Most of the time, the founder or seller of a company stays with the company during the earn-out period to help insure that the company will achieve the desired results.)
