Selling a small business? Pay close attention to this provision.

Entrepreneurs looking to sell their small business will negotiate a number of terms as part of the sale agreement. In many situations, a buyer will insist on an earn-out provision.

What is an earn-out provision?

These provisions are generally one portion of a two-part offer: The first part of the offer involves the buyer providing the seller with cash or stock payout immediately at the closing. The second part involves the seller receiving additional compensation at a point in the future if the business achieves certain financial goals after the closing.

The potential buyer may offer this compensation as a portion of the business’ future earnings.  The potential buyer may put money into an escrow account to provide the seller with some assurance that the earn out will be paid if its conditions are met.  However, often, the earn-out provision will simply be a promise of the buyer to pay the earn out if the conditions are met.

Those in favor of these provisions state it allows entrepreneurs of relatively new businesses the opportunity to receive a large selling price. This can entice a buyer to enter an agreement even if they have concerns about the business’ future performance potential.

What happens if the business does not meet the requirements of the earn-out provision?

These provisions can result in future legal issues. Years after the transaction is complete, a seller may state the earn-out provision was not satisfied. This could result in a dispute and potential litigation between the buyer and seller.

What can sellers do to protect their interests when a buyer demands an earn-out provision?

Sellers can take a proactive approach to protect their interests during negotiations. Two steps that can help address this particular issue include:

  • Keep records. As with any business transaction, it is important to keep records of all documents that impact negotiations. Keep a copy of everything from tax returns to text messages. This can ease the seller’s burden when navigating negotiations in the future if the buyer does not satisfy an earn-out provision.
  • Delegate. Acknowledge that this provision may be out of your area of expertise. Find a legal professional experienced in business law matters to review the offer before moving forward with the sale and discuss potential ramifications. The lawyer can make sure that the provision is carefully written to make clear what must happen for the earn-out to be paid. The lawyer can also make sure that the buyer sets some money aside to assure the buyer meets its obligation when the earn-out comes due.

An attorney may also negotiate a counteroffer that better ensures your interests are protected.