It always sounds easy to bridge a price gap with an earn-out...

Excerpt from ‘The Young Professionals Guide to Conquering Private Equity Transactions’ available on Amazon

Earn-outs (Chapter 5)

An earn-out is deferred consideration dependent upon the future performance of the business being acquired. The principal purpose is to bridge the price expectation gap between the buyer who will pay a price on past profits and the seller who expects a price based on the future potential of the business.

The difficulty for earn-outs is balancing the needs of vendor to run the business and the purchaser to control it. The vendor needs to retain control, the purchaser needs to be involved in shareholder issues – new investments.

Features on earn-outs:

Usually based on pre-tax profits;
Usually based on averages of profits of two or more periods;
Usually between 2 and 4 years;
Targets are usually set in profit bands i.e. profits >£a multiplied by x, profits >£b multiplied by y.

Benefits to buyer:

Smaller initial consideration, “buy now pay later”;
A pool to offset warranty and indemnity claims;
Motivated seller and continued commitment;
Maximum cost is known (if capped);
Secures non-competition.

Disadvantages to buyer:

Harder to integrate;
Difficult to motivate past management;
Cash generated is normally insufficient to meet earn-out consideration;
Need to ensure funding will be available at the end of the period;
The seller may insist on due diligence to provide comfort on the ability of the buyer to pay the earn-out

Benefits to seller:

Higher price;
Employees can benefit;
Retain “directorship” but needs protection in the employment contract.

Disadvantages to seller:

Risk of not receiving full price;
Profit disputes or working capital situation;
Not exit;
The tax treatment of the earn-out consideration can be uncertain;
The payment is dependent upon the financial strength of the buyer.

Practical issues:

Impact of acquisition;
Who can hire and fire staff; and
Accounting policies to be adopted.