Earn-out Plan: A Win-Win Strategy to Pay A Seller for Potential
By Thomas L. Snyder, DMD, MBA, Director Henry Schein Professional Practice Transitions
Most buyers do not want to pay for potential when negotiating a sale price, but sometimes there may be a valid reason to consider it – especially if a recent event has negatively affected practice performance over the past year or two. For example, the value of a practice can sometimes be adversely affected by unforeseen circumstances, such as the loss of a key dental associate, illness of the owner, or other scenarios that may cause a decline in revenue and/or net profit. In these situations, most buyers offer a lower purchase price than what the seller expects. However, there is a reasonable solution to consider which addresses these circumstances. The solution is called an “earn-out”. An earn-out is designed to increase the total sale price over a specified time frame if certain revenue goals are met post sale.
A properly designed earn-out plan allows the seller to receive additional income based on a formula that also ensures the purchaser is receiving a reasonable profit after an earn-out payment. If the earn-out revenue goals are not achieved, no additional payments are paid to the seller. Earn-outs are usually achieved over a 1-3 year period. To design an earn-out plan, the following steps need to be taken.
Step 1. Prepare a Practice Breakeven Point
An earn-out only makes sense if both seller and purchaser benefit from certain targets being met. The simplest way to measure the economic impact of an earn-out is to first calculate the practice’s Breakeven Point. The Breakeven Point (BEP) is calculated by the following formula:
BEP = Fixed Expenses + Owner Compensation
1 – Variable Expense Factor
Fixed Operating Expenses are all practice related expenses such as Facility Expenses, Staff Expenses, General Expenses (i.e. bank charges, advertising, professional fees, computer expenses, licenses/permits, and practice acquisition loans). Variable Expenses are expressed as a ratio of revenue and are collectively termed the Variable Expense Factor. Variable Expenses are office expenses, dental and implant supplies and lab expenses. They fluctuate directly with practice production.
Once the Breakeven Point is calculated, you can then project the economic impact of an earn-out by estimating the additional profit the buyer will realize after the earn-out payment has been made to the seller. Here’s an example for calculating a Breakeven Point which serves as a baseline for an earn-out payment. To begin the calculation, list the appropriate expenses and revenue for the most recent year. The purchaser’s desired compensation, however, is not just based on the prior owner’s income, but also what the purchaser reasonably needs to pay his/her taxes as well as living expenses and dental education debt.
Practice Revenue: $1,200,000
Fixed Operating Expenses: $636,000
Variable Operating Expenses (20%): $240,000
Purchaser’s Desired Compensation: $300,000
(BEP = $636,000 + $300,000 = 936,000 divided by 1 - .2)
$936,000 divided by .80
BEP = $1,170,000
In this case, the Breakeven Point for this practice is $1,170,000. Therefore, every dollar produced in excess of this amount will only cost the practice 20¢ (Variable Expense ratio). This gives the owner a net profit of 80¢ for every dollar produced in excess of the BEP.
The earn-out payment can be the difference between what the seller wanted as a sale price compared to what the purchaser actually paid. In some instances where an illness or other event occurred (for example, a flood closed the practice for a period of time and caused a reduction in revenue and profit), the earn-out payout may be greater than a sale price differential. The number of years for the earn-out payment is ultimately determined by the differential in sale price.
Step 2. Determine a Percentage of Dollars Earned in Excess of the Earn-out Amount to be Paid to the Seller
You can allocate 20-25% in excess of the earn-out revenue goal that will be designated as the earn-out payment for a given year. Again, this percentage is based on the results of the breakeven analysis. Here is an example of how an earn-out payment would work.
Seller’s Asking Price: $840,000
Actual Sale Price: $780,000
Earn-out Payout (if revenue goals met):$60,000
Annual Earn-out BEP: $1,170,000
Time Frame: 2 Years
Earn-out Payout: 25%
Actual Year 1 Revenue (after sale): $1,300,000
-$1,170,000 (earn-out BEP goal)
X 25% (earn-out %)
$32,500 Earn-out Payment Year 1
In this example the practice exceeded its BEP goal by $130,000, assuming it cost 20% (Variable Expenses), which translates into $26,000 of Variable Expenses to generate this excess revenue. Therefore, the purchaser has a gross profit of $104,000. $32,500 will be paid to the seller as the first year’s earn-out payment. The purchaser will net an additional $71,500 plus the $300,000 compensation already built into the BEP model. The purchaser will receive a total of $371,500 in year one.
Remember that when applying this calculation, the practice acquisition debt is already built into the BEP. If the earn-out payment is made over two to three years, the Breakeven Point goal has to be recalculated annually, based on the prior year’s expense history and revenue.
For an earn-out to work, trusting the purchaser to accurately track revenue is critical. To counteract any manipulation of financial data, we structure our earn-out agreements so the seller, at his or her own expense, can retain an accountant or consultant to ensure the earnout calculations are made correctly.
In summary, earn-outs are a great solution when sale price and practice potential come into play. They provide an economic win for both parties if the earn-out goals are achieved!
If you would like additional help, email Dr. Snyder at email@example.com
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