I’ve never seen an earn-out actually get paid

Why that phrase, without context, could make you lose a good deal

“I’ve been involved in many deals, and I’ve never seen an earn-out actually get paid,” said the lawyer my client had hired while reviewing the signed letter of intent (LOI) for a sale we had been working on for months and negotiating for weeks.

Approximately a quarter of the transaction price was subject to a multi-year earn-out, based on the achievement of certain financial targets.

The law firm partner insisted that what had been negotiated was not a good deal and that it would be better to renegotiate the terms so that the entire payment was made at closing.

Frustrating, right? If it had been possible, that certainly would have been the deal.

My client, the business owner, became very nervous and called me, asking me to clarify whether it was true that earn-outs were never paid, what my experience had been in other deals I had advised on, whether it was true that buyers would look for any excuse not to pay, and that, having ceded most of the company and its control, he was “sold out” with practically no chance of ever receiving the variable component.

I wanted to strangle the lawyer, who hadn’t participated in any part of the process and was questioning the foundation of the agreement we had signed. I admit I even thought about calling my client to tell him that the legal advisor he had hired was incompetent, because if they had never seen an earn-out get paid, it was likely they didn’t know how to do their job and had badly negotiated the terms of the sale agreement.

But I held back and explained again why the agreement we had was inevitable: the price was very attractive even without the earn-out, and if we tried to renegotiate, the deal would likely fall apart.

The company I was advising on the sale was relatively small and highly dependent on its founder. We had organized a competitive process, brought several buyers to the table, and managed to negotiate an attractive price and multiples because there were four highly motivated buyers bidding for the company.

All offers included a variable component ranging from one-third to one-fourth of the price. All buyers understood the high dependency of the business on the founder and wanted to ensure he stayed for a few years and continued driving the business post-sale.

Potential buyers knew that if the deal had been 100% upfront, the likelihood that the founder would get paid and then disengage was very high. That’s why all offers were structured with a variable component. If we had tried to force a structure without an earn-out, the deal probably would have fallen through.

What we had done was negotiate an attractive multiple while simultaneously giving the buyer comfort on their biggest concern: that management wouldn’t disappear after closing.

In small transactions with high dependence on the management team, earn-outs are often hard to avoid.

If you want to sell a company, you need to understand why the buyer is making the offer, what they see in your company, and what their biggest fears are. In many deals we negotiate, the main perceived risk is that the founders won’t stay long enough, with the right incentives, to keep driving the business with the same energy as before.

As I jokingly tell my clients, since the abolition of slavery, the only real way to make sure someone stays working is to align incentives with a strong variable component compared to what they’ve already received.

If someone pays €10 million all upfront and the founder only receives their salary from day one — even if it’s a comfortable €200,000 per year — the risk of them leaving at any moment is high.

If the structure is €8 million upfront and €2 million variable — which can become €4 million if things go well — the likelihood that the founder stays increases significantly.

The point is simple: if from the start you signal that you have no real intention to stay, or you aggressively negotiate to eliminate the earn-out or reduce it to a minimal percentage, the probability that the buyer will become nervous and question your willingness to stay and push during the transition — or longer if needed — is almost certain.

You must be willing to demonstrate that you want to stay, that you believe in the project with the new investor, and that you trust in the company’s future growth. Unfortunately, no reasonable buyer is willing to take your word that you will stay without a truly motivating incentive attached.

The role of advisors

The responsibility of the M&A advisor is to help you negotiate an earn-out under achievable conditions. If the company has been growing 10% per year and the earn-out can only be earned if the next two years see a 25% compounded annual growth rate, it’s likely that the earn-out will never be paid.

The responsibility of the legal advisor is to clearly define the protection clauses that ensure the earn-out, including ways to resolve potential disputes, etc.

Now, if you ask me whether earn-outs get paid, in our experience, in the deals we have managed, they are paid in a very high percentage of cases, at least partially. In our experience, in most cases buyers want sellers to receive the earn-out, because if the targets are achieved, it means all parties made a good deal.

Are there times when earn-outs aren’t paid? Of course. Like any variable component, sometimes it isn’t achieved. That’s why the fixed portion must be sufficient so that, if the variable isn’t earned, you don’t regret having sold the company.

By Joshua Novick, Partner atBondo Advisors