Collection Agency M&A: The Importance of Earn-Out Structure

Settling on the structure of a sale is challenging on many levels. Once the purchase price is determined by a buyer and seller, both parties need to figure out how much cash will be paid at closing. Most owners dream of selling their business in an all-cash transaction, but very few companies warrant such a buyout at an acceptable price. Experienced buyers in collection agency M&A prefer to tie some portion of the purchase price to future performance, commonly referred to as an earn-out component.

This is the last part of Kaulkin Ginsberg’s Collection Agency M&A blog series. Part One and Part Two are linked.

Simply defined, an earn-out is a portion of the purchase price that will be paid out to the seller in the future, usually based on revenue generation or profitability by the selling company in question. Earn-outs are used to bridge the gap between buyer and seller when the amount the seller wants to be paid is higher than the amount the buyer is willing to pay at closing. They are commonly tied to the selling company achieving certain goals set by the buyer before closing. 

Understanding that earn-outs exist in most middle market transactions, let’s examine two hypothetical examples when buyers and sellers can utilize an earn-out component in their transaction:

Example 1: The Selling Company Has Demonstrated Little to No Growth in Recent Years

The selling company has lost market share from some long-term clients and lost other clients entirely. However, they successfully offset these losses with growth from existing clients and onboarding new clients. Simply stated, the selling company’s performance has been erratic in recent years and they have experienced little to no revenue growth overall. In this example, the buyer uses an earn-out to ensure that the seller’s revenue will be maintained when the business is integrated into the buyer’s. 

The purchase price is set based upon current performance. A portion of the price is paid in cash at closing and the remainder is made in installment payments over a two-year period after closing based upon revenue performance. To incentivize the seller to increase revenue, the buyer agrees to pay the same amount for any overage that is realized as well.

  • Seller’s Annual Revenue:……………………………$10 million
  • Purchase Price:……………………………………….$8 million
  • Cash Paid at Closing:..………………………………..$3 million
  • Earn-Out Amount:……………………………………..$5 million paid out over two years, tied to retention of $10 million in revenue

At the end of year one, the selling company successfully maintained $10 million in overall revenue. The buyer pays the seller $2.5 million. However, at the end of year two, the selling company experienced a $2 million reduction in overall revenue. The buyer adjusts the purchase price by 20%, or $1.6 million, and pays the seller $900,000 after year two.

Example 2: The Selling Company Has Experienced Explosive Revenue Growth in Recent Years and Has a History of Profitable Operation

The selling company has gained substantial amounts of market share from current clients and successfully brought on some large new ones. They experienced some revenue losses from existing clients, but these losses were minor and completely offset against substantial revenue growth. 

This company is viewed by the buyer as a rocket ship with soaring profitable revenue growth projected into the foreseeable future. In this example, the buyer uses an earn-out to pay the seller for future growth when it is realized. A portion of the purchase price is agreed to be paid out over two years through installments based upon revenue performance.

  • Seller’s Revenue in Current Year:……………………$20 million
  • Forecasted Revenue:……………………..…………….. $26 million in two years
  • Purchase Price:…………………………………………..$30 million
  • Cash Paid at Closing:…………………..…………………$24 million
  • Earn-Out Amount:………………………………………….$6 million paid out over two years, tied to projected revenue growth

After year one, the selling company successfully increased revenue by $3 million. The seller is on course to achieve its full earn-out payment after year two. After year two, the selling company increased revenue by $5 million, exceeding projections. The buyer audits the seller’s performance and pays the full amount of the earn-out plus an agreed upon bonus for exceeding projections.

As you can see from the two examples, earn-outs can be a powerful tool for buyers and most sellers will have to consider the transaction’s structure if they want to be successful. Effectively managing earn-outs can be tricky, however. Fortunately, Kaulkin Ginsberg can help you navigate those choppy waters. We have worked with small, mid-sized, and large privately-owned companies, Fortune 500 corporations, and financial investment firms on their collection agency M&A strategies for thirty years. Whether you’re seeking professional sell-side representation, assistance forming a partnership or joint venture, or a transaction assessment, Kaulkin Ginsberg will guide you through the process. For more information, or to schedule a confidential discussion of your business goals, contact us here or email hq@kaulkin.com.

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