The price a seller puts on their business and the amount a buyer is willing to pay are rarely the same, but in some situations the difference between these numbers is too large to reconcile with simple negotiations. It can be difficult in certain cases to determine what the value of a business should be because the value is contingent upon something occurring in the near future.

Here’s an example: A manufacturing business is on the market, but the owner has just landed a large contract that is going to make the business a great deal of money over the next three years. This contract, if all goes according to plan, will increase the value of the business considerably. The seller of this business will want to be paid for this expected value, as this contract was a long time and a lot of work in the making – but a buyer is not going to want to pay for something that hasn’t happened yet. How do a buyer and seller reconcile these very different opinions on value? They use an earn-out.

What is an earn-out? In this type of arrangement the buyer will continue to pay the seller an agreed upon amount as certain milestones are reached, resulting in a higher value for the business overall. In our manufacturing example, the buyer pays the seller an initial amount. Then, as the manufacturing contract goes into full effect – the business will make more money. When the business hits the agreed-upon milestones, the buyer will then pay the seller for those milestones.

Is an earn-out for me? Probably not. These types of agreements are rare in the small business world, and as you can see from our example, some very unique circumstances need to be in place to make an earn-out work.

In most small business transactions, seller financing is used. This situation occurs when a buyer brings a large down payment and then pays the seller back the remainder over a set period of time.

In both the earn-out and seller financing deals, the buyer will have the advantage of knowing that the seller has real faith in the future of the business because the remainder of the money owed is contingent upon the future success of the business. The seller has the advantage of getting more for their business if the business does well, like in the earn-out situation.

How do I figure out if an earn-out is for me? Ask your business broker. Any experienced business broker has seen what works and what doesn’t in terms of earn-outs. Your broker will be able to advise you on the plusses and minuses of all of your options.

Are you a buyer or seller who is curious about whether an earn-out is right for your situation? Do you have more questions about how earn-outs work? Ask us! Leave us a comment or question here, and we will be happy to help.

Michael Monnot

941.518.7138
Mike@InfinityBusinessBrokers.com