Topic: Professional Services

Subject: Earn Out Agreements
Tim Breen
Member: 2010
Submitted on 08-17-11 12:09 pm
Our company periodically purchases professional service firms in the software installation/consulting space. Recent acquisitions were structured with approximately 50% up front payment and 3 year earn out with the earn out payments based on EBIT performance of the purchased entity. Downside is tension created with former owners regarding their incentive to maximize short term EBIT versus making investments to drive revenue growth.

Any suggestions on other arrangements that keep former owners engaged in growing the business but provide more balanced approach for both purchaser and the acquired?

Tim Breen
itelligence, Inc.
Larry O'Brien
Member: 1997
Posts: 1

Subject: Re:Earn Out Agreements

Submitted on 06-22-12 11:38 am.
As a general rule, the more complex the earn out formula, and the less involved the former owners are post acquisition, the higher the level of tension and the higher the likelihood of a legal confrontation.

If the former owners either continue to operate the business, or have a colleague they trust deeply involved during the earn out period, the better the likely outcome. Often a revenue-based earn out formula will work well, especially if there is a general understanding of the capital investment needed during the earn out period. If you have an earnings-based formula, the former owners will want to have transparency into the expensing, corporate allocation charges, and accounting treatment of the business.

Any formula more complex than a straight-forward operating profit metric has a high probability of prolonged conflict.
Rick Zachardy
Member: 2008
Posts: 1

Subject: Re:Earn Out Agreements

Submitted on 05-09-13 7:32 pm.

My apologies for such a late response. I'm fairly new to this site.

Below are some provisions by way of growth metrics, minimum reserves, covenants and payout mechanics to consider during the earn-out period negotiations to aid in aligning the selling parties' focus with that of yours over the term of the earn-out period:

Growth Requirements:
Operating Margin (And other typical financial metrics)
Gross Revenue
Net Operating Income (EBITDA)
Operational Cash Flow
Enterprise Value
Free Cash Flow

Reserve Requirements:
Working Capital (Maybe use Gross Rev as a basis)
Capital Expenditures (Maybe use Gross Rev as a basis)

Threshold Requirements:
Maximum Effective Tax Rate (Depending on structure)

All the above would be best measured on a current and then cumulative basis from the acquisition date.

A dual payout calculation could be considered as well based on current and then cumulative results.

For example, should current results meet 100% of the earn-out requirements for payment, the cumulative may fall short. In this instance, possibly factor in a holdback reserve until such a point as the cumulative deficit is cured for a period of time or until the next annual payment date.

Much of these thoughts are similar to lender compliance calculations and requirements but just enhanced to incorporate and incentivize company growth.

Please let me know your thoughts.

Take care,

Rick Zachardy
[email protected]
(972) 740-4077
Curt Kroeger
Member: 2016
Posts: 3

Subject: Re:Earn Out Agreements

Submitted on 04-15-16 2:40 pm.

If EBIT is what you are holding someone accountable for, that is the behavior you will get.   So simply make the earn out based on what you want that group to achieve in the coming three years.   Revenue growth?  Recurring Revenue growth?   To me in an acquisition, cost containtment is the easy part.  You should be leveraging infrastrucure and eliminating reduncancies.   Where the rubber hits the road has always been in the pipeline of new business and the forcasted assumptions of growth.   So those are the things I would weight the heaviest in the agreement.  I also agree that simple is better.