Earn outs as a method of paying for a business

Although I would never recommend buying a business is that revolves solely around the current owner (unless of course you want a main street retail business specifically to run as an owner operator), some businesses have a solid enough track record to consider if this is the case.

Earn outs can be employed as a means to pay for a service/consulting based business regardless of the structure of the company but it's a must if the current owner holds the keys to everything. Especially if that includes being the main client manager or consultant.

An earn out basically says that a small amount will be paid to the seller up front with the rest over time, just like with a note. The difference is that in this case, the buyer holds the power and the seller needs to perform to get his/her money.

For example, let's say you're buying an IT consulting business. The details are that it's a 4 person shop including the owner and the owner makes the deals and keeps up with the clients. One other person is an admin and the 2 others are technicians. They have 50 clients.

If the business is valued at $250,000 a typical scenario would be that you will put down $100k to $125k and the rest will be on an earn out over the next 3 years. Let's go with a down payment of $100k.

There are many ways to do it but in this example we'll say the seller is responsible for making sure that you lose no more than 10% of the clients each year over that 3 year period. After each year you will give the seller $50k as long as 10% or less of those clients have left (there could also be a stipulation that the biggest clients can't be lost at all). If more than 10% is lost, you start taking money away.

All of this needs to be clearly spelled out, but it is typical. Keep in mind that a seller that has built a nice base of customers in a service type of business that has mostly repeat/contracted clients is a very good buy. Even if the seller is the main cog in the wheel.

If the seller has too much involvement, there is more risk on your end, which is why you set up the earn out to protect yourself. But an overly involved seller also puts you in a position to get this business for a much lower price valuation. They don't have a leg to stand on in an argument. For some, this is the perfect situation if you have limited funds but the right background to take over the business.

Just remember, avoid banks when you can, especially in this economy. The more you have a broker or other intermediary help you out with using seller funding such as notes and earnouts, the better position you will always be in as a buyer.

Your comments and questions are always welcome.


To Your Business Buying Success-

The Business Buying Guru