How much to ask for as an earnout?

February 09, 2021

by a searcher from Monash University in Melbourne VIC, Australia

I'm a self-funded searcher currently looking at business that supplies equipment to warehouse and distribution centers and am considering an offer. I'm interested in hearing opinions on how much I should ask for as an earn out?

Asking Price - $3m ($2m for business and $1m for stock)

EBITDA - around $800k after adjustments

The business has been operating for over 20 years and the owners (2 guys in their early 70s) would like to retire. It was advertised for sale in 2015, 2016, and 2018 but the owners say they didn't receive any serious offers.

At this stage I haven't come across any major issues that would discourage me from making an offer. Sales can be a little lumpy due to the nature of the business, however it has remained profitable for 5+ years.

How much would be a reasonable amount to ask for as an earnout? 30%? 50%? I want my offer to be taken seriously but I can also see there is potential here for quite a generous earnout.

Reply by a searcher
from INSEAD in Singapore

Sellers note is not a replacement for earn out, since you will still owe them this regardless how poor performance is, even if they tell all their customers to not do business with you after you have taken over.

You should put in an earn out proportion large enough to ensure they are incentivised to help the business and you flourish, but also realistic enough for them to not categorise you as a 'not serious offer'. Also should take into account their health and willingness to continue working/contributing. They are after all in their 70s.

20-30% valuation earn-out would be reasonable. If they want a lower percentage you could ask for a longer period e.g. 5 years instead of 3 years. If they are confident in the business and motivated to help you, they will take it. If they are not willing to take it then the question is whether there is something you don't know.

5 years performance at existing EBITDA would be close to break even if take into account interest/taxes. And if the business performance fail to meet requirements, then you are only 2M out of pocket instead of 3M, again of which 1M is inventory - even if it gets discounted if liquidated (I assume stock means inventory)

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

Earn-out is for risk mitigation. Therefore, it has to be tied to identified risk. For a stable business, in theory, there should be no earn-out. For a small business there are risks even in a stable business due to lack of accounting, owner involvement, poor systems, over-dependency on few employees, etc. A common method to mitigate such risks of a stable business is a seller note, not earn-out. Earn-out is a tool to mitigate risks that are inherent in the business and beyond the control of even the seller. It is a also a tool to bridge value gap arising from differing growth outcomes (e.g., how fast will the new product take off? Will FDA approve the drug? Will a supplier who has not raised prices for 5 years will raise after the purchase? etc.). Notice, I have not mentioned customer retention as a reason for earn-out. Why? Because seller does not know if the buyer has what it takes to run a business. Seller does not want to hand over the keys to someone with such unknown risk. Over my 30+ years of M&A, I have had many all cash offers at full price that the seller turned down b/c seller was uncomfortable with buyer's ability to maintain the legacy.

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