Does anyone have experience with earn out deals?

November 06, 2023

by a searcher from University of Pennsylvania - The Wharton School in New York, NY, USA

Hi Everyone! I am considering a deal where the owner is stepping down because she does not want to continue scaling the company. The asking price is very high, but to make it an attractive offer I was considering an earn-out offer. I see that the seller does not want to miss out on the upside a new owner can create, but when is an earn-out appropriate versus when is the owner being unrealistic? What are factors you have considered when you proposed an earn-out?

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Reply by a professional
from University of Toronto in Toronto, ON, Canada

Thanks ^redacted‌ for including me. An earn-out needs to be carefully structured because it can generate fear of manipulation and mistrust which may kill the deal, or make life with the former owner unpleasant while you're going through the earn-out period. One of my recent deals is a perfect example. In 2021, we were purchasing a dental clinic. Revenue was rebounding from the effects of the COVID shutdowns, but wasn't back to pre-COVID level and it wasn't clear when and to what extent revenue would recover. The business appraisal had been done on the assumption that revenue would fully recover in 2022, and the vendor had set his asking price on that basis. We weren't convinced, so we offered an earn-out based on achieving certain revenue benchmarks in 2022 and 2023 which would have given the vendor his full asking price. However, he rejected our offer because he feared we could manipulate the revenue numbers so that we wouldn't achieve the benchmarks and he wouldn't receive his earn-out. Thus, he perceived the earn-out - which was a positive in the deal for him - as a negative. As the old saying goes: "No good deed goes unpunished!"

Reply by an investor
from University of Western Ontario in Toronto, ON, Canada

I always look at earnouts as a way to bridge value gaps that are legitimate (ie you are not paying me for xx revenue booked next year or my inv in growth or you think there’s a revenue bump from covid and the owner does not). I don’t like them to bridge pie in the sky valuations by a seller.

Some things I’ve learned in giving earnouts:

1) make them short in nature - 1 year. Your work shouldn’t bring them value in the long term. I’ve made this mistake a lot.

2) try to structure them around gm or revenue - not ebitda. Tough to define and gets too complicated.

3) try to figure out the equity creation from the increase in the target to get to the earnout Ie if it’s $2m of revenue to hit the earnout, the ev might increase $500k for example.. Now how much of that should you share? My rule of thumb is 30% or less. You are doing the work and should get the reward.

Just my views…..and I express them to get another free month of searchfunder :).

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