How to structure an earn out to align incentives

searcher profile

November 09, 2024

by a searcher from University of California, Davis in Wheaton, IL, USA

Hey yall,

I'm about to put in an offer for a service business with around 2M in revenue and I'd like to include an earnout or another vehicle to align our incentives over the medium term,

What have you experienced? What has worked and what hasn't? My goal is for the sellers to get the full asking price for their business while incentivizing them to remain and assist with transferring relationships and training.

Thanks!

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commentor profile
Reply by a professional
from University of Michigan in Detroit, MI, USA
Hi ^redacted‌, how are you funding the deal? If with an SBA loan, you won't be able to do a true earn out. Instead, you should ask the seller finance between 10-20% of the deal (you should do this regardless for a number of reasons that I am happy to discuss).

This will align incentives. And if there is a risk that business post close may decline without the seller's strong involvement (like transferring key client relationships), you could make the note forgivable again historic performance (e.g., revenue drops). Of course, if you're funding the deal with a convention loan, you could do an earnout or a forgivable seller note. The former increases the purchase price if certain targets are met. The latter decreases the purchase price if certain targets are not met.

Another option would be to ask the seller to retain equity in the business going forward, with a structured buyout at some point in the future (such as your call option after five years). The seller will then be incentivized to make sure that the business continues to do well. And the seller will also benefit from any upside, which could sweeten the deal.

Happy to discuss these options and others in greater depth. My law firm, Groundswell Advisors, LLP, is focused on serving the ETA community. I'm always happy to help. Reach out at redacted if you want to talk.
commentor profile
Reply by a professional
from Bentley College in Miami, FL, USA
Earnouts can be a great way to keep sellers motivated and aligned with the business’s goals, especially during the transition period. Structuring the earnout based on key metrics like revenue retention or client handover milestones can work well, as it directly ties payout to the seller’s continued involvement and success in those areas. One issue I've seen is where the contract language or milestones are too vague and open to interpretation. You want to make sure that there is a very clear understanding around this.

Here's an article that you may find helpful: https://www.duedilio.com/structuring-earn-outs-in-acquisition-financing/
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