Use an Earn-Out Provision to Bridge The Difference In a New Jersey Business Sale

Sellers usually value their New Jersey businesses higher than the Buyer can reasonably pay up front and unconditionally, because the Buyer has less familiarity with the minute details and unseen liabilities that show up only after the deal is done.  A confident and reliable Seller can be persuaded to accept payments over time, often tied in to the Seller’s continued services to the business, either as a key management employee or as a salaried consultant.  Additional consideration for the purchase can be tied in to achieving revenues or net earnings that the Seller has represented to be achievable, and on which the Seller relied in setting his sale price for the business. The additional payment(s) are considered earn-outs.

We have represented a number of sellers and buyers of businesses where we used earn-out provisions to bridge the differences between what the buyers were willing to pay for the businesses and what the sellers were seeking.  Earn-outs also can come into play for reasons of income deferral for tax or estate planning, sharing the profits with key employees and, for the Buyer, for reasons of confirming sellers’ representation, assuring the continuity of the customer base and for cash flow reasons.

There are a wide variety of structured provisions that can be included in business purchase agreements, depending upon the divergent needs of the parties, and the willingness of the parties to await future results, to compromise and to be flexible, depending upon those future results.  However, there are some common issues that we have addressed in earn-out negotiations.  If you are considering negotiating the purchase or sale of a business, and if earn-out provisions are likely to help bridge valuation differences that usually attend such sale negotiations, then it is worthwhile to plan to address earn-out issues such as determining: (i) the earn-out portion of the total price for the business; (ii) the milestones for achieving entitlement/obligation for earn-out payments; the periods in which to achieve the milestones; and the method of calculating and paying the earn-out amounts.

For example, depending on the strength of positions of the parties, earn-outs may be negotiated to be paid in cash, stock, secured or convertible debt, retained ownership held in escrow, as well as other creative solutions we have seen. Escrow provisions are frequently used to protect the Buyer from unseen or unknown future negative events, such as the loss of a material customer, errors in inventory calculations or bad faith of the Seller in representations made to encourage the purchase.

We have seen that earn-outs and escrow provisions can serve to avoid litigation between the parties when future events do not turn out to be as expected by one of the parties.  By providing for such possibilities in this volatile economic period for businesses, and where changes in the tax and regulatory arenas are expected but unpredictable, a buyer or seller can avoid unnecessary disputes and litigation by providing for such contingencies in advance through the use of earn-out provisions.

If you would like to discuss the purchase or sale of a business, please contact Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work.