How to structure an earn out (and what to put in an LOI?)

December 23, 2022

by a searcher in Burlington, VT, USA

I’m working on my first LOI. I’m wondering how an earnout structure works.

The company’s performance in the last 3 years were not good. I spoke with the owners and they had some bad years due to unforeseen challenges that I deemed to be reasonable. But in the last year, the achieved $1m EBITDA.

I’d like to derisk the transaction by having the owners stay on for 3 years (they seem amenable to the idea) to ensure that the revenue is stable. I’m thinking of pegging the milestones to 2% revenue growth and maintaining the same EBITDA margins.

What are the details that I’d put into the LOI? For instance, do the owners stay on as members of the company, or are they outside consultants?

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Reply by an intermediary
from City University of New York (CUNY) System in Tinton Falls, NJ, USA

Agree with Mark, you can't do an earnout for an SBA loan, but a forgivable note is likely OK. Check with your lender. Keep in mind that an earnout is a benefit to Buyers and not always Sellers. They see it as a potential - but not a controllable one, so be careful on what you expect from them. They (the Sellers) usually have more value in their knowledge of the company's DNA that you can imagine, so be cautious in what you expect from an earnout. As an M&A advisor, we counsel Sellers to accept an earnout when the variable is only revenue or GAAP adjusted GM. All other variables are more susceptible to poor management, which owners have a difficult time accepting. Also, if the earnout is needed to address the basic needs of the Seller to complete a sale, that usually leads to a situation that places a closing in jeopardy.

Reply by a searcher
from Emory University in Atlanta, GA, USA

I was thinking about the same structure. You need to have a very good handle on the margin drivers as the buyer if offering a revenue-based earn out. I was looking at a few businesses where the increased revenue and margin were driven by recent large increases in price due to inflation on key input materials. If price goes down as input material costs fall over time, then your revenue could decrease slowly but your margin could potentially fall at a much higher rate. I do like the fact that you would keep the owners on for an extended time, but note that SBA does not allow you to keep current owners on longer than 12 months after closing. Best of luck, I would love to hear how this goes. Please feel free to send me a DM to connect.

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