More often than not, negotiations to buy/ sell a company start with a significant spread between the ask and the offer. Some of this spread is closed by negotiation, but often there is an unclosable spread between what buyers are willing or able to pay and what sellers are willing to accept.

One common way to close a bid/ask spread is through the use of an earn-out payment. A lot of creativity can go into how an earn-out is structured, and as it does put a bridge over a bid/ask spread, I suspect the use of earn-outs will become more prevalent in the short-term.

An earn-out involves an agreement by the buyer to make future payments to the seller contingent upon the satisfaction or achievement of certain specified milestones that demonstrate the additional value of the seller’s business.

When structuring an earn-out, there are many things to consider. What milestones will be used? How will the earn-out period be defined? How can the seller ensure milestones are being pursued diligently? How can the parties determine if milestones have been met? What payments are due for each milestone? How will disputes be resolved?

Typical milestones for earn-outs are financially based, such as revenue, gross sales, EBITDA or net income. There are limitations on each. “Top line” measures such as revenue or gross sales contain no incentive to the seller to control costs as they run the company through the transition.

Also, warranty payments and returns of goods sold become complicating issues. “Below the line” financial measures like EBITDA or net income can become contentious to measure based upon who gets to keep score. Allocation of human resources, lease costs, finance, etc., between the seller and the acquiring firm all become problematic if not addressed in detail in the purchase and sale agreement.

Nonfinancial-based milestones might include things like the award of a material contract, reaching a safety milestone, issuance of patent or commercialization of a new product or service.

How will the earn-out period be defined? It seems like a simple issue on the surface, but remember small hinges swing big doors. Considerations include how long it takes to measure additional value accurately and how often additional value should be measured. Should a seller receive an earn-out for hitting milestones on each of the first three anniversaries after a sale, or just the third? If all three, does failure to make the first milestone eliminate the possibility of earning future earn-outs?

It becomes apparent that a seller must exercise careful due diligence when addressing an earn-out provision and must consider who has operational control of business during the earn-out period. What happens if the buyer sells the business prior to the end of the earn-out period? What happens if a buyer shuts down or de-prioritizes the business prior to the end of the earn-out period? Potential solutions include operational covenants, acceleration of payments and/or deadlines, and minimum payments.

There are also evidentiary issues such as recordkeeping and access to records. How often will financial statements be provided to the seller and will they be audited? There are operational issues that might include the overlap of service lines. Also, the integration of additional business lines into the acquired business should be addressed.

A commonly overlooked issue in milestones is the “all or nothing” approach versus graduated payments. For instance, if reaching $10 million in revenue is supposed to trigger a $1 million earn-out payment, what happens if the seller reaches $9.999 million in revenue? Should they earn nothing? Should they earn half? Prorated? Other issues that could arise include equity payments, stock registration issues and many others.