Earn-out

Definition
 

An "earn out" is a deal in mergers and acquisitions where part of the purchase price depends on the acquired company's future financial performance.

Description

An earn-out can be a valuable tool for small businesses in acquisition deals. It allows the seller to receive a portion of the purchase price based on the business's future performance, often tied to specific financial targets or milestones. 

This arrangement can benefit both parties, as it allows the seller to maximise their return by demonstrating the business's continued success post-acquisition and providing the buyer with added assurance regarding the company's performance and potential. 

Earn-outs help bridge valuation gaps between buyer and seller, making the acquisition more feasible for both parties.

Importance of Earn Out for small businesses

This is why earn out for small businesses is important:

1. Maximising Sale Price: Earn-outs allow small business owners to maximise the sale price of their company by tying a portion of the payment to future performance. This incentivizes the seller to ensure the business thrives post-acquisition, potentially leading to a higher overall payout.
2. Ensuring Fair Deal: Earn-outs offer buyers a secure way to invest by tying a portion of the purchase price to specific performance targets. This assurance of a fair deal based on the business's future potential can instil confidence in buyers. 
3. Fostering Collaboration: Earn-outs foster a collaborative environment, aligning the interests of both the seller and the buyer in the business's ongoing success. This shared commitment can pave the way for a productive post-acquisition relationship, with both parties striving towards common goals.
4. Bridge Valuation Gaps: In cases where there is a valuation gap between the buyer and the seller, earn-outs can help bridge this divide by allowing the seller to receive additional compensation based on the business's future performance. This can make the acquisition more feasible for both parties involved.
5. Retaining Control: For small business owners not ready to completely exit their company, earn-outs offer a way to maintain control and involvement in their operations post-acquisition. This can be especially appealing for entrepreneurs passionate about their business and want to ensure its continued success under new ownership.

How to calculate earn out post acquisition?

Calculating an earn-out post-acquisition involves several steps to determine the final payout based on the agreed-upon terms. Here's a simplified guide:

1. Define Performance Metrics: First, clearly define the performance metrics or milestones determining the earn-out payments. These could include revenue targets, profit margins, customer acquisition goals, or any other relevant metrics agreed upon by both parties.
2. Set Earn-out Period: Determine the duration of the earn-out period during which the performance metrics will be measured. This period is typically specified in the acquisition agreement and can range from months to years, depending on the nature of the business and industry.
3. Track Performance: Monitor the performance of the acquired business throughout the earn-out period, tracking progress towards the agreed-upon metrics. Use accurate and transparent financial reporting to ensure both parties clearly understand the business's performance.
4. Calculate Earn-out Payments: At the end of the earn-out period, calculate the earn-out payments based on the achieved performance metrics. The acquisition agreement typically outlines this calculation and may involve predetermined formulas or percentages tied to specific milestones.
5. Negotiate and Finalise: Finally, it's important to approach any discrepancies or disputes that may arise during the calculation process with a commitment to fairness and transparency and finalise the earn-out payments. Both parties should ensure the calculation is fair and transparent, considering any unforeseen circumstances or external factors that may have affected the business's performance.

Emerging trends that can affect earn-out for a company

 Some of the trends that can affect the earn-out for a company:

1. Digital Transformation: The rapid adoption of digital technologies can significantly impact a company's performance. Companies leveraging advanced analytics, automation, and e-commerce platforms might achieve better performance metrics, potentially increasing earn-out payouts. Conversely, those lagging in digital adoption may need help to meet earn-out targets.
2. Economic Fluctuations: Economic instability, such as recessions, inflation, or shifts in consumer spending habits, can have a profound impact on a company's financial performance. The ability of a company to adapt to these external factors can either hinder or enhance its capacity to meet earn-out criteria.
3. Regulatory Changes: Introducing new regulations or modifying existing laws can disrupt business operations, increase costs, and reduce profitability. For example, alterations in tax laws, environmental regulations, or industry-specific compliance requirements can significantly affect a company's financial health and its ability to achieve earn-out targets.
4. Market Competition: Increasing competition or market saturation can influence a company's ability to grow and meet performance milestones. Emerging competitors, changes in consumer preferences, and new market entrants can affect sales and profitability, thereby impacting the earn-out calculations.

Example

A notable example of an earn-out in India is the acquisition of RedBus by the Ibibo Group in 2013. As part of the deal, the founders of RedBus had an earn-out arrangement where part of their compensation was tied to the company's performance post-acquisition. 

This structure incentivized the founders to continue driving the business's success and ensured that the integration with Ibibo Group met the expected targets.

FAQ

What is payout?

A payout is the transfer of funds to individuals or entities, typically as a consequence of an investment, insurance claim, or financial agreement. It can relate to a variety of disbursements, including shareholder dividends, settlement payments, and earned profits. In the context of an acquisition, a payout may refer to the payment made to the company's sellers, which might include upfront cash and further earn-out payments dependent on future performance.

How to calculate earn-out from gross sales? 

First, determine the total gross sales during the earn-out period to calculate an earn-out from gross sales. Then, calculate the earn-out payment by applying the agreed-upon earn-out percentage to these gross sales. For example, if the gross sales are ₹1,00,00,000 and the earn-out percentage is 10%, the earn-out payment would be ₹10,00,000.