Building Your Earn Out formula for good and bad outcomes

We were recently involved in a Vendor/Buyer dispute over the terms of an Earn Out.

To clarify Earn Out: In this case, the earn out was designed to allow the Buyer to pay fair market value for the business based on the last two years trailing EBTIDA and reward the Vendor for increases above that baseline going forward for a three year term. The valuation challenge revolved around the Vendor having several very large quotes outstanding. Winning any one of those potential projects created a material increase in EBITDA when received. The balancing act is the Buyer would not pay for what had not happened yet, and how the Vendor should be rewarded fairly for known pending opportunities over and above traditional activity levels. 

The spirit of the agreement was to enable the Buyer to receive the benchmark EBITDA he was paying for. The final agreement established EBITDA levels over and above that bench mark would be paid to the Vendor 100% for the first year, 75% for the second year, and 50% for the third year. Initially this seems pretty straight forward. No exceptional sales and the Vendor receives a fair price. With exceptional sales the Vendor shares a “slice” and the Buyer expands operations and future value of the business. 
What are the primary risks for both sides?
Buyer Risk:
Buyer has little Earn Out risk above the purchase price as the deal was structured on historical driven fair market value. Increased revenues increase value of business going forward.

Vendor Risk:

Vendor side has to identify primary areas of risk and properly support them in the Purchase & Sale Agreement.
  1. What if the new ownership exercise control and decides to focus on other targets and ties up company resources impairing the Vendor in achieving their priorities.  As illogical as that sounds it does happen.
  2. While the Vendor may not have total decision making authority after cashing the Buyers cheque, the Vendor is the expert in what it takes for the business to achieve results. How do you manage who has operational control, how is control managed, and for how long?
  3. Some products and services may take longer than a fiscal year to initiate, complete, and provide. How do you build a cumulative target for a length of time that is fair to both parties?  E.g.: While earn out is paid annually for term of agreement if target missed one year the results for the term can be calculated on a cumulative basis allowing full payment of the agreed amount if the total targets are achieved for the full term of the earn out.
  4. Or, the case where if the target is missed by $1 does that mean a zero payment? The all or none case becomes a poisonous issue if some of the reason for not quite getting there relates to point 1 and/or 2. Is the Buyer an obstacle to the Vendor’s success? Or what if the market is down for no reason of the business? Anticipating flexibility while structuring the agreement supports a long term healthy relationship.
  5. While business models vary, is the fairest model structured on a portion of benchmark targets including some form of incentive calculation or bonus structure? The Vendor’s primary goal is the achievement of additional payments. The Buyer’s primary goal is achievement of a higher rate of return. This requires establishing some type of stepped calculation e.g.: 20% less than target receives modest payment prorated to some form of payment (or bonus) schedule.

Earn outs typically reflect future opportunities and rely on the status quo to be achieved. The modeling for individual business structures requires intelligent recognition of market ups and downs, personalities, and fair outcomes. 

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