In merger and acquisition, the Earn-out is a business pricing structure in which the seller of the business obtains additional compensation after the sale with subject to certain financial goals if achieved.
In the Earn-out arrangements, the price is structured in such a way that an initial amount is paid at the time of acquisition and the remaining amount is considered as deferred balance, which is only payable if certain goals are achieved.
Beta Company has an annual turnover of $450 million with net income of $60 million. Another company within the same industry wants to acquire the beta company for $240 million but the current owners of the beta company assume that the bid is undervalued and expecting that earning of the company will grow in coming five years. An expected purchase consideration that may please the seller might be: a cash payment of $240 million and an Earn-out of $210 after the sale if the company maintains its gross profit ratio of 35% up to three years or $150 if sale increased by 20% in coming year.
Advantages of the Earn-out Arrangement
From the buyer’s point of view, the Earn-out arrangement makes it easier to pay for the business sale and less investment is required as compare to cash arrangement. The financial risk of the business is minimized as deferred amount is linked to sale, resulting in less chance of negative cash flows.
From the seller’s point of view, if the takeover bid is undervalued then they can be compensated for financial performance in future.