What Is an Earnout? A Guide for Small Business Transactions
In the context of a business sale, an earnout is a financial arrangement where a portion of the purchase price depends on the business meeting specific performance milestones or targets post-acquisition. While there are many reasons to buy or sell a business, the transaction usually happens because of the potential for growth and success. Earnouts are commonly used when there is uncertainty about the future performance of the business being acquired, where it’s common for a buyer to want more evidence of success.
Rather than paying the full amount upfront, the buyer opts for additional payments based on the business's post-acquisition performance, ensuring that the interests of both buyer and seller are in sync. This arrangement offers a win-win situation, as it allows the buyer to reduce risk and gives the seller the potential for additional compensation based on the business's post-sale performance.
When Is an Earnout Used?
Earnout clauses are used when the buyer is uncertain about the future performance of the acquired business. An earnout can bridge valuation gaps between the buyer and the seller. A seller may even be willing to accept a lower purchase price with a potential earnout if they truly believe that performance metrics can be met to validate value.
Who Should Consider an Earnout?
A seller’s financial advisor or business broker can audit the marketplace and help their client understand the valuation of their business. A seller who is confident in their business or product and wants to see it succeed may be more open to an earnout to prove the business’s worth.
Sellers considering an earnout are more willing to align the purchase price with the contingency that the business can meet agreed upon milestones. As outlined by the negotiations, payout potential may also incentivize a seller to take a lower sales price. Simply put, if the seller believes they can prove the company’s worth and a delayed earnout is worth the effort, they may be eager to help the buyer meet specific targets. A tax advisor may also point out opportunities that favor the seller during an earnout.
Buyers may be open to buying a business with an earnout as part of the purchase price, since it minimizes risk and validates a business’s growth potential.
What Factors Are Used to Determine How an Earnout Is Structured?
Many factors come into play with a merger or acquisition. How the earnout is outlined varies by business and the goals of both the buyer and seller. These factors include:
- The time period of the earnout, which may be months, quarters, or years
- Performance metrics, including financial performance, EBITDA (earnings before interest, taxes, depreciation, and amortization), and customer retention rates
- Financial metrics, including earnout targets and payment potential that benefit the seller, and performance assurance and risk mitigation that benefit the seller
- The formula or method of calculation that determines the profit share from a business’s success after sale
- The relationship between the parties after the sale and during the earnout period, including the extent of the owner’s involvement post-acquisition
- The earnout payment structure that benefits the sellers and owners, including investors, founders, managers, and staff
- Reporting and communication expectations during the earnout period
- Handling unexpected material changes in the industry that affect performance and financials
- Termination events or covenants that void an earnout agreement
Advantages and Disadvantages
An earnout is designed to mitigate risk for both the buyer and seller, but there are still a variety of advantages and disadvantages for each party.
Advantages include:
- A shared and vested interest in the future success of an acquired company
- Lower upfront pricing for the buyer and the ability for the seller to bridge the valuation gap
- Key employees are retained. Retention within the business fosters synergies and makes it easier to achieve earnout goals.
- Incentivized performance for the seller to meet financial and performance metrics
- Flexibility. An earnout’s amortization meets the expectations of both buyer and seller in terms of performance targets, earnout payment terms, and involvement.
Disadvantages include:
- The potential of disputes when terms of the earnout are ambiguous
- Complexity requiring thorough oversight by legal teams representing both parties
- Terms that a seller agrees to may be based on faith in a company’s ability, but they’re not guaranteed.
- Focus on short-term earnout metrics can distract the seller from long-term goals of the business beyond the earnout timeline
- The seller faces the possibility of lack of control
- Feelings of over or undervaluation based on the performance of the business during the earnout period
- Cultural and operational integration challenges between the new owner and sellers’ management teams
Examples of Earnouts
Different business acquisitions require different earnout structures.
- In a profit margin-based or revenue-based earnout, a buyer may agree to an earnout provision that gives the sellers an additional payment after two years of sustained growth or for having met gross profit goals.
- In a customer retention-based earnout, payments may be contingent on the company's ability to retain its current customers.
- A startup with an innovative product idea may have an earnout from a private equity firm after the product is developed and proves to be successful.
Enlisting Professionals to Structure a Deal
Business brokers and legal representatives do more than dispute resolution during business sale transactions. They must be involved when negotiating earnout criteria and planning the deal structure. Their due diligence includes reviewing financial statements, depreciation, potential changes in cash flow and more to ensure the acquired company has the expected potential.
The logistics and performance metrics are set in a legally binding manner in conjunction with the purchase agreement, making it imperative that representation protects the interests of both parties.
Furthermore, retaining those advisors and lawyers is helpful throughout the entire earnout process. They can help manage disputes, minimize conflicts related to the acquisition agreement, and manage communication. Head over to the BizBuySell Broker Directory to find a qualified business broker who can provide valuable assistance in structuring and negotiating your business for sale transaction.