Tony Samples
So, the last 1-2 years, you have seen a decline in sales and profits. You know that you have a great business and that it will rebound in the coming years. Buyers get the vision, but aren’t willing to pay for it up front. Therein lays the “valuation gap.”
One way to bridge this gap is simply for the seller to wait for the value to go up. For those sellers ready to sell now, the gap can be closed through an earn-out. In an earn-out, a portion of the purchase price is contingent upon the business reaching certain milestones. If the milestones are met, the seller shares in the upside. If the milestones are not met, the buyer hasn't paid for an increased value that never came.
For example, using easy math, Charlie owns a machine shop that supplies automobile parts that has a current value to a buyer based on recent performance of $400,000. Charlie knows that orders and sales are going to increase over the next few years as the economy recovers and his clients start ordering more parts. Because of this future value, Charlie wants to sell his business for $500,000. Joe wants to buy Charlie's machine shop and agrees that the business will likely grow substantially over the next five years, but doesn't want to pay $100,000 for sales that may never materialize…
Joe offers Charlie $400,000 for the business plus an additional $50,000/year for the next five years if certain revenue thresholds are met. Charlie agrees to the deal because he is confident that Joe will achieve those thresholds and he believes that he will make more money in the long run. The buyer and seller have successfully used an earn-out to bridge the gap. This example shows the earn-out based on revenue targets, this is the most common measurement, but it could just as easily be tied to employee retention, gross profit, net profit, customer retention etc.
Earn-outs can be very helpful in certain situations. In the example above, the seller is arguing that the historical financial results are not indicative of future potential. They also work well when a business has had a huge increase in sales over the last one or two years and the buyer is concerned if the sales are sustainable.
Important Note: An earn-out can not be used if the transaction involves an SBA loan, however under certain circumstances, a forgivable promissory note can work.
Contat us to learn more about buying or selling a business and, if there is a gap, know that we’re equipped to help you close it.
