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Six Reasons Why the Sale of Your Business Might Require an Earn Out

Will I have to take an earn out when I sell my business? 

This question comes up within five minutes of every conversation with a business owner who is considering selling their company.  Most business owners are understandably skeptical about a selling with an earn out, because there are legends about earn outs promised but not paid.

A good business going to market with a reasonable valuation represented by a capable and experience business broker will generally NOT have to take payment in the form of an earn out.  But, in my 25+ years of deal management, I have seen earn outs used when one of the following six factors are at work in the sell of a business.

#1 The business valuation is based on future projections. It rather stands to reason, if the valuation is premised on future potential of the business, it is fair for the business buyer to pay only if that future potential is realized.

#2 The business has a customer concentration problem. The definition of concentration will fluctuate given 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 40% or more of a business’ revenue comes from one customer, the business is considered to have a concentration problem.  The buyer’s concern is that once the owner/seller is gone, that one customer might be gone too causing a big drop in the business revenue.

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

#4 The business is being represented by inexperienced or incompetent intermediary.  A smart buyer can sense a weakness.  Even a good business will find itself subject to an earn out if the buyer pushes hard against an inexperienced broker.  A corollary problem is a broker’s willingness to allow an earn out because the broker just wants 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.  In those situations, all the bargaining power is on the side of the buyer, who will likely push as much of the valuation to an earn out as possible.  A hasty exit is usually induced by an external event, like divorce, partner split, a bad health diagnosis, loss of a key employee or customer, etc. 

#6 The business can’t sell 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 is 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.

An entire blog post can be written on why earn outs are a bad idea, generally speaking.  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.

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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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