It is no great insight that acquirers of companies want to only pay for an acquisition based on today’s earnings and book value. However, Sellers want to sell their company based on tomorrow’s expected earnings.
Public companies have the advantage of being able to offer their publicly traded stock as currency in an acquisition.
Private companies are not so lucky to have stock to use, their tactic to “pay up” for an acquisition often is the Earn-Out.
According to James W. Bradley, co-author of Acquisition and Corporate Development:
“The earn-out is a contingent purchase which allows some deals to go through that would otherwise be impossible. Sometimes the seller’s price is such that the transaction can only be justified by the buyer at levels of future earnings considerably above what the buyer can expect with any degree of certainty. Here an earn-out may allow the deal to be consummated. Under certain circumstances, earn-outs may qualify as non-taxable transactions.”
Earn-outs can be complicated. But they are used often and especially under these circumstances:
- The seller has very high price expectations
- There is a significant selling price expectation gap between buyer and seller
- The buyer has limited capital
- The acquisition of service companies or other types of relationship companies.
- Acquisition of companies introducing many new products.
- The owner/seller is willing to stay involved in the business for two or five more years.
In acquisitions involving earn-outs, the acquirer usually puts a maximum earn-out or “cap” on the deal. The acquirer wants to be sure that the income from the earn-out is derived from continuing operations and non-recurring or extraordinary factors. While a specific dollar amount is often not pre-determined, the acquirer wants to make every effort to please the sellers. The buyer wants future sellers to know they are good to work with.
If the seller accepts an earn-out, a more aggressive pricing strategy can be used. Keeping in mind that the earn-out objective is to quantify the uncertainty for the buyer, they can be used to bridge pricing expectation gaps between the buyer and the seller. Sometimes earn-outs are used to protect the buyer who has not or cannot perform adequate due diligence. This is not a good use of this device for the buyer.
Earn-outs should really be limited to bridging the pricing expectation differences between the seller and the buyer. Also, it can used by the seller to spread out income in taxable transactions. The success of how these are used is dependent on how creative and flexible the parties are.
Earn-outs are common. If you are selling your company, an earn-out will likely be part of the deal structure.
