Question & Answer
How Can a Founder Negotiate a Fair Earn-Out Agreement?
Earn-out agreements can be a useful tool in deal structuring, allowing founders to receive additional compensation post-sale based on the company’s future performance. While they align incentives between buyers and sellers, they can also be complex and risky if not properly structured. Founders need to negotiate fair terms that protect their interests while ensuring they have control over achieving earn-out targets.
What Is an Earn-Out Agreement?
An earn-out is a deal structure where part of the purchase price is deferred and contingent upon the business meeting certain performance milestones post-acquisition. These can be tied to revenue, profitability, customer retention, or other key business metrics.
Common Earn-Out Structures
- Revenue-Based Earn-Out: Payments are contingent on the company reaching specific revenue targets.
- Profit-Based Earn-Out: Compensation is tied to net income or EBITDA, ensuring the company remains financially healthy.
- Customer-Based Earn-Out: The payout depends on customer retention or acquisition metrics.
- Time-Based Earn-Out: The seller receives payments over a set period, regardless of performance.
- Hybrid Earn-Out: A combination of multiple criteria, balancing financial and operational targets.
Challenges with Earn-Outs
Earn-outs can be tricky to navigate. If not structured correctly, founders may struggle to meet targets due to external factors beyond their control, such as changes in market conditions or strategic decisions made by the new owners.
Example: A founder sells their SaaS company with an earn-out based on revenue growth. However, after the sale, the new owners shift their focus away from sales expansion, making the revenue targets harder to reach.
Negotiation Strategies for Founders
To secure a fair earn-out, founders should focus on the following:
- Define Clear and Achievable Targets: Ensure the metrics are specific, measurable, and realistic. Avoid vague performance goals that could be subject to interpretation.
- Set a Reasonable Timeframe: Earn-outs should have a defined period—typically one to three years – to avoid being drawn out indefinitely.
- Retain Influence Over Key Decisions: If the earn-out is based on company performance, the founder should have a say in strategic decisions that affect revenue, hiring, and budgeting.
- Negotiate Partial Upfront Payment: If possible, structure the deal so that a significant portion of the purchase price is paid upfront, reducing dependence on earn-out conditions.
- Include Protections Against Operational Changes: Prevent the buyer from making changes that could unfairly impact the founder’s ability to achieve earn-out milestones.
- Agree on an Independent Auditor: If the earn-out is tied to financial metrics, ensure that a neutral third-party accountant verifies the calculations.
Alternative: Using Debt or Equity Instead of an Earn-Out
Earn-outs aren’t the only way to structure a deal. Founders can negotiate alternative structures that provide financial upside without excessive risk.
Debt-Backed Agreements: Instead of a contingent earn-out, a founder may secure a fixed deferred payment backed by a promissory note.
Equity Holdbacks: Instead of an earn-out, founders can retain a minority equity position in the company, ensuring long-term upside with less dependency on short-term performance targets.
A well-structured earn-out agreement should align incentives while protecting the founder’s ability to achieve success. The key is clarity – well-defined terms, enforceable protections, and a fair balance of risk and reward.
Deal Structuring
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