As a California business broker, I have facilitated deals which used earn outs. An earn out is a method of compensating sellers over time. An earn out is generally a formula that dictates that the owner receive a percentage of the revenue or profit for a defined period of time. Business brokers often suggest an earn out as a way for buyers and sellers to compromise when they cannot agree on price.
Earn outs are not uncommon. A recent Business Week article noted that 30%-50% of acquisitions involve an earn out. Generally the earn out portion is 15-30% of the purchase price - however with very small businesses, that are highly relationship based, a small down payment with an earn out may be the only way to sell a business.
An earn out is also a viable option when a business falls into one or more of these categories:
Client based service business
Owner "is" the business (very small)
Sales very dependent on the owner's relationships
Customer concentration issue
Highly speculative business
Rapidly growing business
Declining business / turnaround
Business is very dependent on the owner's expertise
Lenders will not finance
Unlike carrying a note, where the payments are fixed, the payment may fluctuate depending on sales. In both cases sellers have some risk but in the case of an earn out, sellers have a greater interest in ensuring a smooth transition and continued growth. A business acquisition is an investment in the future earnings of the enterprise. An earn out is a tool buyers use to mitigate risk.
For the Seller an earn out means:
Differed compensation, often lower taxes
It may mean greater total compensation than without an earn out
Sellers maybe more involved with the business post-sale that otherwise
If the business falters there may be a period of time where the payments cease or decrease
Viable tool for a partner buyout
For the Buyer an earn out means:
Mitigation of risk
Means of retaining clients / customers
Sellers are often more involved with the business post-sale that otherwise
An opportunity to acquire a business that is higher risk / more speculative
Bonus payment or balloon payments may be due if certain targets are met
The owner has a financial interest in the transition
If you are a successful business owner in the Southern California area and would like a professional business broker to help structure an earn out for your business, I would be happy to speak to you. All inquiries are confidential and there are never any upfront fees. Please contact me today.
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