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Earn-Outs – Pros & Cons

When selling a company, one common method of structuring the deal is through an earn-out payment arrangement, but what are the earn-outs – pros & cons?

An earn-out payment is a type of payment that is contingent upon the future performance of the business. The buyer and seller agree on certain metrics, such as revenue or profits, that the company must meet within a certain time-frame in order for the seller to receive additional payments beyond the initial purchase price.

In this discussion, we will examine the pros and cons of earn-out payments for both seller and buyer and how they can impact the sale of a company.

Pros of Earn-Out Payments

Higher Purchase Price: One of the primary benefits of an earn-out payment is that can allow sellers to receive a higher purchase price than they would through a traditional sale. By agreeing to an earn-out payment, sellers can receive additional payments if the company performs well after the sale. This can be a significant advantage for sellers who believe that their company has strong growth potential but may not have realised that potential yet.

Risk Mitigation: Another benefit of earn-out payments is that they can help mitigate the risk for buyers. By structuring the payment in this way, buyers are incentivised to ensure that the company continues to perform well after the sale. If the company does not meet the agreed-upon metrics, the buyer will not be required to pay the earn-out payment. This can help protect buyers from overpaying for a company that may not perform as expected.

Alignment of Interests: Earn-out payments can also help align the interests of buyers and sellers. In a traditional sale, the seller may have little incentive to ensure that the company continues to perform well after the sale. However, with an earn-out payment, the seller is incentivised to work with the buyer to ensure that the company meets the agreed-upon metrics. This can help ensure a smoother transition of ownership and increase the likelihood of long-term success for the business.

Cons of Earn-Out Payments

Uncertainty: One of the main drawbacks of an earn-out payment is the uncertainty involved. Since the payment is contingent upon the future performance of the business, there is no guarantee that the seller will receive the additional payments they are hoping for. Additionally, there may be disagreements between the buyer and seller regarding the interpretation of the metrics used to determine the earn-out payment.

Lack of Control: Earn-out payments can also result in a lack of control for sellers. Since the payment is contingent upon the future performance of the business, sellers may feel that they have less control over the success of the company after the sale. This can be especially challenging for sellers who have invested significant time and resources into building the company and may feel that they know best how to ensure its success.

Tax Implications: Earn-out payments can also have tax implications that should be carefully considered. Since the payment is contingent upon future performance, it may be treated as deferred compensation for tax purposes. This can result in additional taxes and can impact the overall value of the earn-out payment.

Conclusion – Earn-Outs – Pros & Cons

Earn-out payments can be a useful tool when selling a company, but they should be carefully considered before being included in the sale agreement. Sellers should be aware of the potential benefits and drawbacks of an earn-out payment arrangement and should work with their legal and financial advisors to determine whether this type of payment structure is appropriate for their specific situation.

Ultimately, the decision to include an earn-out payment in the sale agreement should be based on the goals and objectives of the seller and the overall strategy for the sale of the business.

Acting for our clients in sell-side deals, we are highly experienced with negotiating various deal structures, including earn-outs and deferred consideration, that facilitate the optimum position for our clients.

To discuss your business exit, please contact us in confidence here.

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