10 critical success factors for earn-outs: Part 1

Earn-outs Cropped

If you’re planning on selling your consulting firm, it’s highly likely that the transaction structure will contain an earn-out. In fact, 90% of deals involving consulting businesses will have a structure which includes some sort of deferred payment, with most taking the form of an earn-out. Your objectives would normally be to maximize the up-front cash percentage and alleviate the earn-out terms. Therefore it is worth being aware of the complexities associated with earn-outs and having access to the knowledge which will allow you to structure it in the most sensible and beneficial way. Our Buyers Research has a chapter on earn-outs and you can access the report here.

Earn-outs can be used by a buyer for any number of reasons but some of the most common are:

  • To obtain commitment from the vendors post transaction
  • To introduce specific targets which are non-financial to ensure a smooth transition post deal
  • To mitigate a valuation based on the delivery of a high growth forecast
  • To lower the day one funding requirement; and
  • To bridge a gap in price expectations between vendor and buyer by allowing a higher headline value

Earn-outs are not one-size-fits-all and must be tailored for specific circumstances. However there are 10 over-arching considerations that should be taken into account. We’ll be looking at the first 5 in this week’s blog, with the final 5 to follow next week.

1. What should the earn-out target be?

Set it too high and it becomes a disincentive, too low and it won’t be incentive enough. The target should be achievable for the vendor and provide a mechanism which ensures good value, driving the right behaviors for the buyer.

It is difficult to provide qualitative advice on what a target should be as clearly every situation will be different; however you should consider the following:

  • Base the earn-out on your existing organic business plan as you should be able to deliver this as a standalone entity, and it should only be enhanced by the buyer’s infrastructure and client base – assuming minimal interference in the way you run the business
  • Whilst it is usual for a buyer to want to have a cap on the earn-out, it doesn’t normally make commercial sense for either party as the additional consideration from exceeding an earn-out is usually self-funding. Get a thorough understanding of what the combined business opportunity is, and use this to assess the risk of hitting earn-out targets
  • Conversely, ensuring you include adequate downside protection within the earn-out is also key. This should ensure you still receive some value from it, even in the case of missing the target. However, for obvious reasons, this is a much more sensitive discussion
  • Avoid linking large proportions of the earn-out to specific targets with binary outcomes

2. Avoid complex, many-variable structures

Complexity of earn-out structure makes it very difficult to negotiate and document legally during the transaction, and also difficult to measure post transaction. The result is excess negotiation during the process and subsequent arguments post deal.

Trying to make an earn-out achieve many different outcomes is fraught with difficulty. At its most simple an earn-out should drive behavior which creates value and growth for the acquirer.

3. What happens if you leave?

Ensure you know what happens to the earn-out payments if you have to leave part way through, either through your own choice or a forced exit. There are many ways to ensure that you are protected in this case.

4. Consider the implications to the integration process

Earn-outs can sometimes be a hindrance to integration of the vendor’s business into the buyer as typically the vendor’s business needs to be ring-fenced from a reporting and operating standpoint in order for the earn-out to be measured. This can destroy value for the buyer and also completely undermine the original rationale for undertaking the acquisition in the first place.

5. Earn-out payments rely on the financial viability of the buyer

Being satisfied that the buyer will still be solvent at the end of the earn-out period, or including protections in the sales documentation, is key.

Check back in next week for the second 5 critical factors for earn-outs. Or if you can’t wait, please view the full article this blog is based on here.

Are you a member of Equiteq Edge? It’s full of content to help consulting firm owners prepare for sale and sell their business. Register here to gain full access.

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