Earn-out in business sales: assessment basis

If buyers and sellers cannot agree on the sale price or the future of the company during the business sale, an earn-out can help. Then, the purchase price consists of a fixed, immediate cash payment and a success-dependent additional payment at a later date ("Earn-out"). Today we will show you the possibilities for determining the amount of the Earn-out.

The amount of the Earn-out depends on the success of the company. To represent the success of a company, there are several metrics. It is important that one is chosen that does not create false incentives for either the seller or the buyer. If the seller remains as the CEO in the company, he naturally wants the additional payment to be as high as possible and so it can happen that he increases the profit, albeit in a business-damaging way. If, on the other hand, he has no or only little influence on the day-to-day business, the buyer can press the result to achieve a lower Earn-out.

Which metrics are suitable as a basis for assessment?

Mostly, business economic metrics that are visible in the income statement of the company to be sold are used. An example of a basis for assessment is a percentage of the future EBITDA (operating profit before interest, taxes, depreciation, and amortization). However, several figures can also be linked to set the right incentives for both parties. A very good solution is, for example, linking the newly won order book with the EBITDA margin. In this way, the seller has the incentive to win as many new orders as possible and at the same time, by linking with the EBITDA margin, it is ensured that the company is profitable. The more orders won and the higher the profit, the higher the additional payment.

Basic rules for an Earn-out

• The goals that serve as the basis for the amount of the Earn-out must be detailedly defined by both parties.
• The derivation of these goals must be comprehensible.
• The target sizes should not be based on the subjective assessments of the parties, but should be derived from verified conclusions and official documents.
• Regular communication between the parties (buyer, seller, and management) is advisable to make the process transparent and to prevent misunderstandings.
• The agreed procedure along with the agreement regarding the selected metrics are recorded in the so-called Earn-out clause in the purchase agreement.
• An examination of the tax implications of this regulation (possibly even by ruling) is recommended.

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