Earn-Outs in Mergers and Acquisitions

Part one: Types of Structures

Earn-out structures are commonly used in mergers and acquisitions (M&A) to bridge valuation gaps and align the interests of buyers and sellers. These structures allow a portion of the purchase price to be contingent on the future performance of the acquired company. There are several different types of earn-out structures used in M&A:

• Revenue Earn-Out:
• The seller receives additional payments based on the target company's future revenue performance in a revenue earn-out. The earn-out amount is typically calculated as a percentage of the target's revenue exceeding a predetermined threshold.
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) Earn-Out:
• EBITDA earn-outs are based on the target company's future profitability as measured by its EBITDA. The seller may receive additional payments if the EBITDA exceeds agreed-upon targets.
• Gross Margin Earn-Out:
• This earn-out structure is tied to the gross profit margin of the acquired company. Sellers may receive additional payments if the gross margin surpasses specified levels.
• Customer Retention Earn-Out:
• In a customer retention earn-out, the seller is rewarded based on the ability of the buyer to retain key customers or contracts after the acquisition. Payments are contingent on maintaining a certain customer retention rate.
• Product Development or Milestone-Based Earn-Out:
• This structure is linked to the achievement of specific product development milestones or goals. Sellers receive payments when certain product-related targets are met.
• Time-Based Earn-Out:
• Time-based earn-outs are based on the seller's continued involvement in the business post-acquisition. Payments are made over a specified period, contingent on the seller's continued employment or advisory role.
• Profit Margin Earn-Out:
• Similar to EBITDA earn-outs, profit margin earn-outs are tied to the target company's profitability, but they may use metrics like net profit margin or operating profit margin as the basis for additional payments.
• Market Share Earn-Out:
• Market share earn-outs reward the seller based on the target company's ability to gain or maintain a specific market share percentage within a defined period.
• Hybrid Earn-Out:
• Hybrid earn-outs combine multiple performance metrics, such as revenue, EBITDA, and customer retention, into a single earn-out structure. Payments are made based on a combination of these metrics.
• Performance Vesting Earn-Out:
• Under this structure, the earn-out payments vest progressively as specific performance targets are achieved. The seller may receive a percentage of the total earn-out amount for each milestone reached.
• Escrowed Earn-Out:
• In cases of uncertainty about the target's future performance, a portion of the earn-out amount may be placed in escrow. The seller receives the escrowed funds once the earn-out conditions are met.

It's important to note that earn-out agreements can be complex and require careful negotiation and drafting to ensure that both parties' interests are adequately protected. Disputes can arise if the earn-out terms are not clearly defined, so it's essential to have a well-drafted agreement that outlines the specific metrics, conditions, and timelines for earn-out payments. Legal and financial advisors often play a crucial role in structuring earn-outs to ensure fairness and clarity for all parties involved.

Sellers who fail to understand the market value of their company and the full range of adjustments and other complex factors involved in a sale may leave money on the table in closing a business sale.

I am an experienced deal-maker, CPA, and Certified M&A Advisor. I successfully guide business owners to their best understanding of the market value of their company and then produce full-valued outcomes in a business sale.

ABOUT US

Whether you want to sell or buy a business, Chapman Associates provides a personalized service based on our sixty-nine years of successful M&A closings and our relationships with more than 9,600 registered buyers.

Chapman is one of the most respected middle-market M&A firms in the country. What makes Chapman different from the competition?



• We make a market for our clients.

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• Our fees are based on completed transactions.

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• We help clients set realistic goals and work hard to exceed them.

• We conduct in-depth research and rigorous analysis.

• We prepare all necessary offering materials.

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Mark Mroczkowski, CPA, CM&AA

Managing Director 

mark@chapman-usa.com

www.chapman-usa.com

407.580.5317