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Earn-Outs


Dear Dave
We have been discussing the idea of selling our firm to another area practice as a way for my partner and me to retire and, at the same time, see to the continuation of our practice in the interest of our staff and clients. Everything seems like a go and we are now down to working out the final details of the transaction. The deal offered consists of about one third cash at closing, one third long-term note, with the final third tied to the level of actual billings and profits over the first three years following the sale. Is this practice common? Should we be concerned?
LK TX

Dear LK
The overall structure of your deal is not unusual. Some cash, a note, or even the seller accepting some stock in the acquiring firm as part of the purchase are all pretty typical. The final third, tied to post-sale performance is referred to as an earn-out. An earn-out makes the ultimate final price variable and tied to future performance.This helps take away some of the risk of overpayment from the buyer, and allows the seller to receive top-dollar based on how well the firm does in the first few years following the transaction.

As a seller, your concern with the earn-out portion needs to focus on specifically what the earn-out payments are tied to and how they will be calculated. If tied to future profits, you will need to have a good definition of “profit”. If the acquiring firm begins to allocate additional overhead and other expenses to your firm, any future profits you may have anticipated to be there could be gone. If tied to sales and or profits, what if there is a business slow-down or the new owners turn out to be bad managers and the business sours? Are you willing to accept a reduced ultimate price for circumstances beyond your control? To achieve its intended purpose, any earn-out needs to be carefully thought out, well defined and clearly measurable in order to be fair to buyer and seller alike.

 
 
Wahby and Associates