What is an Earn Out?

“Earn out” sales terms are often found in the equity exchanges of accounting practices. In these exchanges the equity paid to the seller is based on a percentage of annual fees collected from only those clients that transfer to the buyer and continue to use the services of the buyer, and then only for a fixed number of years.  These terms embed the fairness criteria described in the Fair Commission Model (FCM). Click here for a description of these criteria. The seller only receives the “commission” for those clients that transfer to the seller. The buyer pays the commission only for a fixed number of years (usually five to seven). The annual rate usually does not exceed 20% of the retained client revenue during the buyout period insuring that the buyer is adequately compensated for servicing these clients.

An Earn Out Shifts Risk

A significant motivation for earn out sales is that these terms effectively shift the risk of loss from the buyer to the seller. Although the buyer still has some risk, the seller is most at risk in such transactions.  If the seller contracts with a buyer who is unacceptable to the existing customers, clients, or patients (CCPs) those CCPs will go elsewhere and the seller will get very little on the sale transaction.                                                                             

The level of risk assumed by the buyer in deferred sales based on retained clients is clearly less than the acquirer risk in the sale of publicly traded equity. If the purchaser of a professional practice sold under these terms is unable to retain any of the seller’s former CCPs, the acquirer pays the seller nothing beyond the down payment.

The CCPs Often Benefit from Earn Out Sales

Because of the risk of loss, the seller has a financial incentive to seek a buyer that will provide CCPs with the best possible level of service. This is the optimal buyer who will retain the greatest number of CCPs. 

Lack of Buyer Liquidity

Another common motivation for utilizing earn out sales terms is the fact that buyers may not have sufficient liquidity to pay for the full value of the equity upfront. Third party lending may not be an option for these buyers. The equity value of many closely held firms lies mainly in their goodwill, which is an intangible asset. Many traditional third party lenders are reluctant to lend on goodwill because they prefer to collateralize loans on tangible assets like land, building and equipment.

For more on earn out sales click here.

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