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

There's a new Sheriff coming to town...

... but don't wait on him to clean things up if you're looking to buy a business.

Like I often preach, if you're looking to buy a small business, the banks are not your best source of funding. That means waiting until the banking mess is cleaned up is a bad idea and honestly doesn't even effect your ability to buy a business as long as you have a source of down payment funds.

If a business is on the market, the seller already knows that. They also know they have no choice but to hold a note. At this point, it will probably be a much bigger note than the traditional 30 to 50%. you may actually get away with only putting down 30 to 40% with a 60 to 70% note.

Good businesses with boomers looking to retire are out there for sale. Waiting a few years to buy a business is not going to make things better. When the credit issues are clearing up, sale prices will be on the rise.

Besides, the best way to control your own destiny in tough economic times is to get yourself into a business where the effects of the economy are minimal. People still have to buy things and things still need to be made.

Businesses still need to keep their doors open. And they will.

The question is... will you be one of those business owners?



To Your Business Buying Success-

The Business Buying Guru