Earn out considerations & language

January 08, 2020

by a searcher from Duke University - The Fuqua School of Business in Short Hills, Millburn, NJ, USA

I'm looking for ways to structure an earn out. In particular, I'd like to review approaches that include both financial and non-financial (customer/employee retention, key hire, etc.) criteria. Appreciate if you could send language used to redacted what situations would one use an earn out versus a seller note forgiveness. Finally, what are some consideration one would take into account for the duration of the earn out. Thanks.

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Reply by a searcher
from University of California, Berkeley in El Dorado Hills, CA, USA

Sanjay - Happy new year! Good to see a post from you and sounds like you're getting close to a deal. There are a lot of questions in your post but as you probably know most earn-outs are contingent on revenue or profitability targets being achieved. You can structure them on a sliding scale too (or tiered) where there is a bigger reward or share to the manager on greater achievement. I would add a word of caution on earn-out structuring particularly if you made material changes to the operations of the business during the earn-out period. You do run the risk of exposing yourself to litigation. Typical durations is 12 months. Just be careful if you extend the duration of the earn-out your might create a behavior that is not ideal for the objectives of the business. Make sure you have alignment along EBITDA growth if that's what you're trying to achieve but ensure that it doesn't come at the cost of future revenue growth.

Reply by a searcher
from Harvard University

Couple of things to add - you can add a linear formula to debt forgiveness (so its not binary), this is usually more palatable to a seller (because also limits gaming the mechanism). Also - the simpler the better (revenue vs income). The lower you go in the P&L the more complicated... If selller in involved in things after sale, just be mindful of ensuring that anything he does that can affect the metric you choose is on similar terms as historical (e.g., if sales, the sales need to be on similar terms/margins as historicals - you don't want to incentivize poor quality sales enabling zero debt forgiveness). Regarding retention, i would tie to only very key people and make it binary with a cutoff, and with specific amounts.

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