What is an Earn-out?

An earn-out is a way for the buyer to pay part of the purchase price on the future performance of the company. The buyer pays a portion of the purchase price upfront, and pays the rest if and when the company meets specified goals. For example, if the seller thinks the business is worth $2 million and the buyer believes it is worth $1.5 million, they could settle on an initial price of $1 million, and the earn-out would provide the seller with another $1 million if the seller meets the goals specified. Earn-out periods tend to be spread over several years (usually 2-3 years). Usually 15-30% of the total is contingent on an earn-out, but that number can be as high as 50% in some deals.

Why Use an Earn-out?

Many times buyers and sellers cannot agree on a company’s value. The seller will usually point to strong growth trends, and the acquirer will emphasize the uncertainties and risk in the marketplace. If the seller’s representations about future growth and revenue are correct, then the seller should reap the reward. However, if the company experiences a massive downturn in sales or if key employees leave after the acquisition, then the acquirer will have overpaid. Hence, the earn-out is a mechanism to share the risk so that the seller is rewarded if the company does well and the buyer can mitigate some of his/her risks if sales fail to materialize. Earn-outs are particularly common for companies where success depends on a small group of key employees, where the assets acquired are a small portion of the transaction, or where the majority of the value is based on future growth.

What is a personal guarantee and what different forms do they take?

What do these words mean and what are the liabilities? The term “personal guarantee” translates to a person providing a pledge or assurance for an obligation. A person pledges to make good on an obligation.

Personal Guarantee.

This is a weak guarantee. Hard to enforce as it requires legal action.

Promissory Note.

Similar to a personal guarantee. It sets out the terms and conditions of the note. Again requires legal action to enforce.

GSA – General Security Agreement and PPSA – Personal Property Security Agreement.

These have more teeth than the previous two. They provide a lender with a security interest in all of the borrowers present and after acquired personal property including inventory, equipment etc. (Again legal action is required to enforce).

Share Escrow Agreement.

This is the best method (for the Seller to use). Offers great security. The shares of the purchaser’s company are held in trust pending the lender fulfilling their commitments. In the event of failure to comply or honor the terms of the loan within a specified period the Lender simply takes over the ownership of the shares. Such shares are typically signed over ahead and held in trust (in preparation for such an action). No court action is required to exercise this option and hence is the best form of security (for the seller).