The benefits and drawbacks of earn-out clauses during a business sale
The usage of earn-out clauses in the context of selling a company is on the rise. The benefits and downsides that every business owner should weigh are discussed below.
Earn-out clauses are common in business agreements, and they allow sellers to ‘earn’ a portion of the purchase price based on the success of the company after the deal closes. An earn-out term typically lasts between one and three years after the transaction date.
Earn-out clauses are commonly included in sales for two main reasons:
- To reconcile differences in the purchase price anticipated between the seller and the buyer. Earned outs are a sort of ‘at risk’ compensation. The company will be rewarded by the vendors with a higher sale price if a great business result is produced.
- Offer incentives to sellers who stick around after a deal has been made in order to keep the company moving forward.
Earn-outs have many benefits:
- The final sales price is tied to the seller’s and the buyer’s performance.
- It could help close a deal when a disagreement over price has stalled negotiations.
- If the earn-out is calculated in a clear and quantifiable way, there shouldn’t be any more large disagreement between the parties.
- When a company’s income is falling short, when there are innovative new projects underway, or when the company is experiencing rapid expansion, equity is created.
- The company can afford the additional sale price with the growth it has already achieved.
The success of an earn-out arrangement depends on the business potential and legal agreement. If done correctly, they can improve a company’s ability to maintain and pass on its success.