Earn Out Agreements

Brokers Law

An earn out agreement is a provision in a Purchase and Sale Agreement where a portion of the consideration being paid by the Buyer will be based on reaching certain agreed upon targets in the operation of the business AFTER the business has been sold to the Buyer. The additional compensation is earned by reaching the Agreed upon target or the compensation that is earned by reaching a portion of the goal. Earn Out Agreements are often tied to key personnel, the owner for example, staying on and helping to manage the transition. An Earn Out can be an incentive for the selling owner to make certain that a profitable transition occurs. Earn Out agreement can be aspirational in nature or can be more of a minimum guarantee of a certain level of performance. Earn Out Agreements are often based on one or more of the following criteria:

Sales, Net Sales, Collected Receivables, Net Income, EBITDA, Sales Growth and Earning Growth

Example of Earn Out Agreements

Seller will receive an Earn Out Bonus of 10% of All Sales from the Date of Purchase through the one year anniversary of the Sale, provided that the Sales meet or exceed 100% of Sales Amount in the Year preceding the Sale.

Seller will receive an Earn Out of 100% of Collected Receivables on the Books at the Date of Closing that are collected in the next 12 months, less any applicable chargebacks.

During the period of Owner Transition during the next 12 months or such earlier time should Owner for any reason cease affiliation with the Company, Seller will receive an Earn Out Payment equal to 20% of the Gross Margin of all sales from New Customers (i.e. Customers who have not purchased from the Company in the last three years).

Seller will receive an Earn Out Bonus of 15% of the Purchase Price provided the Company reaches EBITDA of Two Million Five Hundred Thousand in FYE 2022 or Seller will receive a bonus of 25% of the Purchase Price provided the Company reaches EBITDA of Three Million in FYE 2022.

Seller will receive an Earn Out of $200,000 provided Net Sales are $1,500,000 over the next 12 month period. Additionally, Seller will receive an Earn Out of $300,000 provided Net Sales exceed $2,250,000 during months 13-24 after the date of Sale.

Seller Preferences

In most cases Seller’s would ideally prefer that all of their compensation is received at the Closing table with a minimal Earn Out or Holdback. Based on the business and the quality of the due diligence this can often be achieved.A business that is properly marketed and in high demand can dictate better terms. Also and significantly, a Seller will not want to leave a portion of their compensation in the hands of a new Buyer who may not be as skilled in operating the business.

Buyer Preferences

Conversely, if a Business is struggling or has significant contingencies surrounding the sale an Earn Out Agreement may be more appropriate.Buyers’s preferences predictably will tend to prefer as much of the Sales Price be deferred or in the form of an Earn Out Agreement. Buyers will prefer this for a number of reasons-less cash up front, uses the profits of the business to pay for the business, and is a guarantee of a minimum level of performance. Earn Out Agreements are a form of added insurance that the business will continue to perform well after the sale or the price will be effectively adjusted by failure to achieve Earn Out hurdles.

Reconciliation of Earn Out Agreements

The specific language of the Purchase and Sale Agreement should clearly and understandably set out the terms and conditions of any Earn Out Agreements and, just as importantly, detail the procedure for reconciling and payment of the Hold Out Agreement. Being precise in the drafting of the agreements and the reconciliation procedures is important as parties’ attitudes to the sale may have shifted in the intervening time periods after the sale. Many Buyers a year or two out from the Sale may be looking to minimize any further payments to the Sellers. Clearly identifiable and measurable standards work best in eliminating post closing conflicts as to Earn Out Agreements. Provisions oftentimes will refer to audited statements, earnings prepared in accordance with GAAP accounting or may have a third party arbiter, such as an Accountant, mediator or other arbiter.

Holdbacks or Expense Escrows

Holdbacks or Expense Escrows technically are different than Earn Out Agreements in that a portion of the consideration that will be paid to the Seller will be held back, for example 10% of the Purchase Price, to address any Seller expenses or claims that may arise after closing for a designated period of time. . An example would be 10% of the Purchase price is held back for 6 months to give the Buyer comfort that any proper expenses or claims against the seller are accounted for. There will typically be a mechanism for addressing these types of claims.

The Buyer will submit a list to the Seller of reconciling items that should be deducted from the Hold Back (Customer returns, Bad Debts, Warranty issues, for example). If the Seller agrees with the reconciling items they are deducted from the Holdback and the Buyer remits the balance of the Holdback to the Seller. If the Parties disagree they will exchange relevant information until they reach agreement or ultimately may resort to the procedures in the Purchase and Sale Agreement for conflict resolution.

Significant Individual Matters may have a Holdback specifically for that contingency. An example of this would be in the purchase of a Company that is involved in litigation. The parties could agree that $500,000 of the Purchase Price will be held back until the case is resolved and any judgments or costs would be deducted from the $500,000 holdback. In the case of holdback for Litigation, as in this example, there would be multiple sections of a Purchase and Sale Agreement devoted to addressing a potentially significant claim (Who handles the litigation, Buyer or Seller, who has authority to settle, Who chooses the attorney’s and other similar issues).

Earn Out Agreements & Holdbacks are one of the areas in a Purchase and Sale Agreement where the Buyer and Seller have very different interests.Obviously on the Sale side of a transaction it is best for the Seller to receive all of his compensation at the closing and walk away from the table whole and Buyers will want as much protection as they can negotiate.

In our experience if a business is on a very positive trajectory it is often not difficult to negotiate an Earn Out Bonus that becomes payable only upon significant growth as a Buyer will only be liable for the earn out if the Company has had significant improvement since the date of sale.