10 critical success factors for earn-outs: Part 2

The process of growth of income

In one of our recent blog posts we outlined why earn-outs are commonly used by buyers and looked at the first 5 considerations  to take into account when thinking about an earn-out. This week, in part 2, we look at the final 5 aspects to reflect on when it comes to earn-outs.

6. Set a realistic time period

The effluxion of time means that an earn-out is at risk from the vagaries of market conditions, customer losses, technological advancement and increased competition, to name just a few factors. A 2 or 3 year period is typical – obviously the shorter the better for a vendor. Our research highlighted that while the average length of earn-out was just less than 3 years, prolific buyers (those who bought more than 2 businesses per year) were more likely to prefer a shorter earn-out period. Knowledge of buyers’ behavior is invaluable in these negotiations.

7. Limit the basis of an earn-out to aspects of the business you can control post deal

For example, if your business is heavily reliant on marketing spend to achieve sales growth and post transaction you have no control of the marketing budget, then immediately you are putting the achievement of your earn-out at increased and unnecessary risk. A full assessment of the transaction situation pre and post deal will highlight any areas of concern.

8. Corporate overheads

Be aware of any ‘costs’ which might be added to your P&L by a buyer post transaction and which could limit your chance to achieve your targets. Knowing how a buyer will behave post transaction and getting these issues on the table for discussion early is a key role for any advisor.

9. Tax treatment

With any performance-based payment there is a risk that the tax authority in your jurisdiction will look to treat it as income rather than capital with the attendant increase in tax that comes with it. Get good tax advice early.

10. How should it be structured?

All or nothing earn-outs don’t tend to work, so typically a sliding scale with caps and collars to penalize underperformance and reward over performance are the norm. A thorough understanding of whether the buyer’s aims are purely financial or whether they are mostly strategic has an impact here.

Will it be possible to catch-up payments later? How is performance to be measured – quarterly, annually, on average?

There is considerable scope for an earn-out to go wrong which is why it’s important to get external advice on how to best structure them. Understanding the motivations of a buyer and then formulating a structure which meets those expectations, whilst protecting you as a vendor, is the ideal scenario. A buyer will want an earn-out to be achievable and so will take guidance from the vendor and their advisor about how best to structure it as a win-win.

To read the full article this blog is based on please click here.

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