Practice owners often misunderstand corporate deal terms.  We have written this article to provide some clarity about “earn-outs”. What they are, how they are used, why they exist and when they are used.

What is an Earn-out?

An earn-out is a deal structure in business sales where a significant portion of the price is paid upfront (for example, 70-80%) and the remainder (in this example 20-30%) of the purchase price is paid later, contingent on the business hitting specific financial targets (like revenue or profit or both) in the future.

You will find earn-outs commonly used in corporate dental practice acquisitions/sales.

Why are earn-outs used?

An earn-out is typically used as a risk mitigation device in large transactions. In short, a vendor accepting an earn-out deal is usually guaranteeing that they will stick around post sale and ensure:

• a smoother and more assured transfer of knowledge and goodwill from the vendor post-sale. 
• that the future performance of the practice will remain the same or better

This guarantee reduces the risk of the purchase for the buyer and, as a result, earn-out deals often attract a higher valuation. 

What are the limitations of earn-outs?

1. This structure will not work if the vendor cannot or simply doesn’t want to be responsible for practice performance targets post sale.
2. The vendor will need to feel enough compatibility with the buyers to work with and for them for this period.
3. In order to be responsible for the financial outcome of the practice post sale, the vendor will need to feel that the buyers will allow them to have enough control of the operational variables, like the practice’s operating hours, fee structure, consumables ordered, advertising, patient allocation and auxiliary staff hiring and firing.  

What if I get sick, injured or the practice floods during the earn-out?

If you don’t make the target due to factors outside of your control, like sickness, injury or flood, the contract of sale can allow for an extension of the earn-out period, to allow you to make up for this unproductive time that is out of your control. However, this isn’t always agreed to by buyers and any clauses related to this would need to be negotiated in advance (if possible).

Are earn-out targets “all-or-nothing”? What happens if I miss the target by $1?

The answer to this depends upon the strength of your negotiation.

Are earn-outs the same as vendor finance? 

In short, No.

While both earn-outs and vendor finance involve money being withheld from the total agreed price on the date of settlement, with vendor finance there is an obligation on the purchaser to pay the vendor the money withheld, regardless of the practice performance post sale.

Vendor finance is extremely rare in the sale and purchase of dental practices, mainly because it is usually relatively easy for dentists to get finance from banks/finance brokers for reasonably priced practices.

If a purchaser needs vendor finance in a deal, it is usually because:

• There is something wrong with the practice (for example: the asking price is too high) OR
• There is something wrong with the purchaser (for example: they may already owe too much money or have some other quality that makes them too risky to lend money to).

In summary

Earn-outs are a complex and often necessary part of large business sale structures that need to be negotiated carefully, to ensure that the vendor is rewarded for efforts and protected from things out of their control. Expert advice on these clauses from commercial lawyers and experienced dental practice brokers is highly recommended.