Bridging the valuation gap by way of earn-out
Link Business Brokers
Due to the difficulties in structuring an earn-out, they have been perceived as something to be avoided at all costs. They can often lead to disagreements and litigation. As Vice Chancellor Laster stated in the recent Airborne Health decision, “ . . . an earn-out often converts today’s disagreement over price into tomorrow’s litigation over outcome.”
However, if set up and managed correctly, they can be very effective, as buyers look to mitigate their risks and sellers look to achieve the best possible price for their business.
I have been involved in the sale of three businesses involving earn-outs, in the past 12 months.
Earn-outs depend to a large extent on good faith being established between the vendor and buyer. They work best when used for strategic reasons, to grow the business and create a winwin situation, so that business is allowed to prove its worth. They are least effective when used purely as a method of financing the acquisition.
In each of the three sales, the buyers achieved their asking price, however a percentage was deferred upon satisfaction of certain benchmarks, relating to either revenue or profit. Some of the issues encountered were:
• the use of cash or accrual accounting during the earn-out period
• revenue and expense allocation
• timing of revenue recognition
• the treatment of one-off or non-recurring items,
• inter-company transactions
• uncollected receivables.
It is imperative that vendors and buyers seek out the best advice when entering into an earn-out arrangement.