Setting a price for the sale of a business can be tricky and is often based on the vendors subjective view on what they believe the business is worth. Conversely, a buyer may undervalue what the business is worth because they have no guarantees that after buying into the business it will continue to operate ‘business as usual’. This is where an earn-out clause can come in handy and be beneficial for both the buyer and the seller.
Business transactions often include earn-out clauses where the vendor ‘earns’ part of the purchase price based on the performance of the business after the sale date.
Typically, an earn-out will be operational for a period of one to three years after the transfer date and can be any agreed percentage, usually between 15% and 30%.
An earn-out clause will usually entitle the seller to a percentage of proceeds of the business if certain agreed targets are met. Although there is no set formula, the earn-out clause targets can be based on many different factors, typically calculated as a percentage of net income, revenue or net profit before tax.
From a practical standpoint, this means that if the seller has over-represented the value of the business at the time of sale, the buyer is protected from overpaying on the purchase price. However, if the sellers projections turn out to be accurate the earn-out clause provides a mechanism for the vendor to be rewarded.
There are two main reasons to include an earn-out clause in a sale contract:
- To bridge a gap in the sale price expectations between the vendor and the purchaser. The earn out represents an ‘at risk’ form of consideration. If the business produces the result, the vendors are rewarded through a higher sale price.
- To incentivise the vendors who are continuing to work in the business and maintain the growth momentum of the business post sale.
Advantages of earn-outs include:
- The ultimate sale price has a performance component to it – both buyer and seller benefit.
- May assist in achieving a sale where negotiations over price have reached a stalemate and would otherwise prevent the sale being finalised
- If the calculation of the earn-out is transparent and easily measurable, there should be no dispute between the parties.
- Creates equity where the business has lagging income, new business initiatives in play at the time of sale or a high growth rate.
The key to an effective earn-out clause is in the construction, both from a commercial and a legal perspective. Get it right and it can enhance the continuity and succession of a business. Whether you’re considering buying or selling a business, it’s important you get the contact right.
Contact our commercial lawyers for help drafting the agreement or for help understanding the most effective way to structure the earn-out clause of the contract.
