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The Earn Out: Painful Stretching to Make a Shaky Deal

Will I have to take an earn out when I sell my business?” Drew (not his real name) was ready to sell his company but he was scared. “I hear horror stories about business owners selling on an earn out which ends up not being paid. I can’t afford to let that happen.”

Not one to mince words, I decided to level with him. “Drew, a good business with a reasonable valuation represented by a capable intermediary will generally not have to take payment in the form of an earn out.”  To which is quickly replied, “That sounds perfectly reasonable, so does my business meet that standard?”

Having been involved in business transactions for almost 30 years, I’ve seen earn outs used many times. Simply stated, an earn out is when some/all of the transaction value is paid in the future if/when pre-determined metrics are met. While the results are not always terrible as Drew feared, there are six situations that generally require an earn out.

#1 The valuation is reliant on future projections that are substantially more aggressive than historic results. It stands to reason, if the valuation is overly-reliant on future potential, it’s fair for the buyer to pay only if/when that future potential is realized.

#2 The business has a customer concentration problem. The definition of concentration will fluctuate given a variety of factors such as the industry, the nature of the revenue stream, and the historic stability of that stream. But in general terms, if 20% or more of a business’ revenue comes from one customer, the business is considered to have a concentration problem. The buyer’s concern is once the owner/seller is gone, that one big customer might be gone too, causing a dangerous revenue drop.

#3 The business is overly reliant on the owner/seller. Similar to the customer concentration concern, a buyer wants assurance that once the business is sold and the seller is out of the picture, the business will not fall apart. This can happen when the owner/seller has all the customer relationships or handles some fundamental aspect of the business process. In situations like these, it is reasonable for the buyer to expect that some of the valuation be paid over time as the business performs to expectations.

#4 The business is being represented by an inexperienced or incompetent intermediary. A smart buyer can sense a weakness. Even a good business will find itself subject to an earn out when the buyer pushes hard against an inexperienced broker.  A corollary problem is a broker’s willingness to advocate an earn out just to get a deal done. It’s the downside of a percentage-based commission; the broker wins even if it’s a bad deal for the client.

#5 The business comes to market and the seller needs a hasty exit. Another weakness I see too frequently is when the seller has to sell for some externally induced reason, such as a health crisis, the need to fund a divorce, or the loss of a key customer or employee, etc. In those situations, all the bargaining power is with the buyer, and they’ll likely push as much of the valuation to an earn out as possible.

#6 The business can’t be sold unless the owner agrees to an earn out. Yes, there are those situations when the business just doesn’t have much operational value, so the only way for the owner to get any value when selling is to agree to an earn out. Under the theory that something is better than nothing, this is not a bad alternative. There are also times when there is an underlying flaw/risk in the business, and the only way to keep a buyer motivated is to move some of the acquisition risk to the future.

Suffice it to say, if you take your stable company to market on a reasonable valuation, without the stress of having to sell it, and you have competent representation, you should be able to avoid the challenges of an earn out.

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee.

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Tennessee Valley Group

Jim is an attorney (non-resident status with the Missouri Bar) and though he no longer practices law, he has read and negotiated enough legal documents to fill a cargo tanker. He has an MBA from Harvard Business School and knows how Wall Street and private equity operates. Jim is a Tennessee Supreme Court Rule 31 listed general civil mediator with tons of experience helping business owners (large and small) work through sensitive problems to achieve winning results. He is the author of "Home Run, A Pro's Guide to Selling Your Business, Seven Principles to Make Your Company Irresistible."

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