What is an earn-out and when should it be utilized in a transaction?
When buying or selling a company, the parties often face a challenging task: determining a fair price that reflects not only the current value of the business but also its future potential. In these situations, a suitable solution may be the so-called earn-out—a specific mechanism that allows for bridging differing price expectations and distributing risk between the seller and the buyer.
What is an earn-out?
An earn-out represents a structured approach to determining the purchase price, where the total value of the transaction consists of two components: a fixed amount paid at the closing of the deal and a variable amount, which depends on the future performance of the company over a predefined period following the acquisition (typically 2 to 5 years). This additional payment is contingent upon achieving specified performance criteria.
Example: When selling a marketing agency, an initial payment of 20 million CZK may be agreed upon at the closing of the transaction, with an additional payment of up to 15 million CZK distributed over the following three years, provided the company meets predefined targets in terms of EBITDA growth, retention of key clients, and expansion of service offerings.
When to use an earn-out?
The earn-out mechanism is particularly suitable in the following situations:
1. Differing opinions on the value of the company - if there is a significant difference between the seller's price expectation (based on optimistic projections of future growth) and the buyer's (based on a more conservative view), an earn-out allows for bridging this discrepancy.
2. Companies with a short history - in startups or rapidly growing companies with limited historical financial results, where valuation based solely on historical data is problematic.
3. Management continuity - in cases where it is desirable for the original owners to remain in charge of the company after the transaction and have motivation for further development of the business.
4. Highly volatile industries - in sectors that are subject to significant fluctuations or undergoing transformation, where it is difficult to reliably predict future performance.
Example: A technology startup with an innovative product but currently limited revenues may be valued at 50 million CZK with a base payment of 30 million CZK at the closing of the transaction and an earn-out of up to 20 million CZK tied to achieving specific milestones in acquiring new customers and revenue growth over the next three years.
Key parameters of an earn-out
When structuring an earn-out mechanism, it is essential to pay attention to the following aspects:
a) Measurable performance criteria
A successful earn-out must be based on clearly defined and objectively measurable criteria. The most commonly used include:
· Financial indicators (EBITDA, net profit, revenue)
· Operational metrics (number of customers, volume of contracts)
· Milestones in product development or expansion into new markets
b) Time horizon
The typical duration of an earn-out period ranges from 2 to 5 years. A shorter period may not provide sufficient time to realize development potential, while a longer timeframe increases uncertainty and complicates company management.
c) Degree of autonomy
A key aspect is defining the degree of autonomy of the original owners in managing the company during the earn-out period. It is essential to establish in advance what decisions they can make independently and which require the consent of the new owner. After all, they will be the ones motivated to increase
Risks and pitfalls of earn-outs
Despite the undeniable advantages, earn-outs also carry certain risks that need to be considered:
a) Conflict of interest
Original owners may be motivated to maximize short-term performance at the expense of long-term sustainability to achieve the maximum earn-out.
Example: The management of a software company may postpone necessary investments in developing a new generation of products to maintain a high level of EBITDA during the earn-out period, which may jeopardize the company's competitiveness in the long term.
b) Complex contractual documentation
An earn-out requires detailed contractual arrangements that take into account various scenarios of future developments, which increases transaction costs and prolongs the negotiation process.
c)