What Is an Earn Out Agreement?
When the owner of a business sells, the buyer may demand an earn out agreement. With an earn out agreement, the seller receives part of the sale proceeds at the time of the sale, and receives additional proceeds if the business meets performance goals, such as earning a specific level of profit, or reaching a certain number of sales.
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Buyer
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The main purpose of the earn out agreement is to protect the buyer. A buyer may have difficulty calculating a value for the company it purchases, especially if the company is in a newer industry, or was recently founded. The buyer may also ask for an earn out agreement if the buyer's financial projections do not match the projections of the seller, or if the buyer does not have enough time to perform a complete valuation analysis of the company.
Seller
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For the seller, the earn out agreement serves as either a guarantee, or a performance bonus. When the seller receives much less than the current market value of the business at the time of sale, the earn out agreement is a guarantee. If the buyer pays close to the market value of the company at the time of sale, the earn out agreement serves as a performance bonus for the seller, especially if the seller remains in control of the company and manages it for the buyer.
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Financing
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Because of the reduced purchase price, the earn out agreement acts as seller financing. A buyer that cannot come up with the full cash price of the business can use an earn out agreement so that it can pay for the rest of the business' price later. The buyer doesn't have to pay interest on the portion of the purchase price it will pay in the future, unlike a loan, which may allow the buyer to make a higher bid than other potential buyers.
Risk
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An earn out agreement creates risk for the buyer if the seller continues to operate the company. If the earn out payment depends on the seller's return on assets, the buyer may make decisions it otherwise would not make, such as liquidating equipment, to improve this ratio. The buyer can include a clause in the earn out agreement that states that the buyer must manage the company in the same way it was managed before the sale.
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