As a highly promising startup you might already have, or in the near future will, become an interesting target to buyers willing to acquire your company. During the negotiation process that follows, an earn-out scheme is something that might be brought to the table. In this newsflash, we would like to briefly inform you about what an earn-out scheme entails.
An earn-out scheme in short is an agreement between the buyer and the seller of a company, pursuant to which the seller must ‘earn’ part of the agreed purchase price payable by the buyer, based on the performance of the company after the acquisition. An earn-out scheme is often used to overcome the difference in opinion between buyer and seller in the valuation of the company, but can also be used as a nice mechanism to keep the founders of a company on-board, involved and dedicated during the earn-out period. In this last case, the work that the founder put in will have a more or less direct impact on the company’s performance and therewith on his own entitlement to the agreed earn-out payments. An earn-out normally takes place over a three to five year period after closing.
Example of an earn-out
Let’s say you want to receive a purchase price of € 3 million Euro for the total share capital of your startup. However, the buyer is of the opinion that a purchase price of € 2 million Euro is more appropriate and that your growth projections are overly optimistic. To bridge this gap, the buyer and you might agree on a purchase price of € 2 million Euro and an additional payment of an amount of € 250.000 per year over the next four years, if certain (financial) criteria, measured on annual basis, are met (plus a little extra in case your involvement with the company after the acquisition is required).
Limitations to the earn-out
This sounds like a win-win solution. However, issues may arise with the earn-out scheme. For example discussions may arise in respect of whether the (financial) criteria for being entitled to the earn-out payment have been met, for instance by a difference in interpretation of the accounting principles. Also, in the event the founders are not required to stay involved during the earn-out period, the buyer may be inclined to somewhat limit or manipulate the results of the company so as to avoid the agreed target being met. Finally, for an earn-out to be effective, the business of the startup needs to operate as envisioned at the transaction date; an earn-out scheme is not conducive to changing business plans in response to future market or business issues.
As briefly outlined above, an earn-out scheme is a good way for a buyer to keep you as the founder involved and motivated to achieve the highest possible profit for the buyer following the acquisition. Besides that, it may also very well be a good way for you to receive a higher purchase price for your startup. Do bear in mind that in the structuring of such a scheme attention should be paid to the terms and conditions of your entitlement to such payment, and that even if this is done well, these will still allow room for lengthy discussions on the interpretation of the agreed terms of the scheme.