A powerful tool in negotiating a business’s purchase price, an earnout can bridge the gap between the amount that a buyer is willing to pay and the seller is willing to accept.
One of the roadblocks that commonly arise in structuring a business sale stems from differing viewpoints of value. Most sellers see maximum profit potential, while most buyers see risk and past earnings. Sellers will typically focus on their company’s recent performance, while buyers will average the company’s performance from previous years. This can make it difficult for the buyer to gain comfort and protection and the seller to achieve the desired profit.
The Earnout Concept
When an impasse occurs, an earnout can bridge the value gap between buyer and seller. Earnouts involve a certain future dollar amount that the buyer agrees to pay to the seller based on the performance of the business after the transaction is completed.
Put another way, Investopedia defines an earnout as “a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings.”
In everyday terms, in the negotiations for the purchase of a business, the buyer’s half of the dialogue might go something like this:
“OK, Mr. Seller, you think your business is worth $50 million. You might be right, but we’re not so sure. We think that, today, it’s worth $40 million. How about we give you that now, and the other $10 million will be paid out of earnings over the next three years if we achieve EBITDA of (fill in the blank).”
Needless to say, an actual earnout agreement will be more detailed than that, but you get the concept. Earnouts can be structured in a number of ways and can be based on a variety of financial benchmarks, such as a revenues, gross profits, or net income. (See “Terms” below.)
In a typical earnout, the potential benefits to both parties are significant.
- A deal gets done, and the business sells.
- The earnout provides potentially maximum value to the seller without increasing risk for the buyer.
- The buyer gets the business now at a lower price, and the seller has a chance to recoup the difference down the road.
- If the sale occurs in a high-interest-rate environment, an earnout can help narrow the gap created by debt coverage.
- If the seller is willing and able to stay on in a meaningful capacity, their continuing presence (and knowledge, skill, reputation, customer retention, and profit motive) should help the seller achieve his earnout goals while delivering additional profit and value enhancement for the buyer.
Other benefits are more buyer focused. For example, if the business has customer concentration issues, an earnout can help protect the buyer by tying sales price to client retention. Similarly, if the subject company is a professional practice, the buyer might be unwilling to pay top dollar without assurance that the seller’s clients or patients will stay. Utilizing an earnout ensures that the buyer pays only for retained clients/patients and gives the seller incentives to pass all relationships on to the buyer.
The language and structure of the earnout should be clearly established when the business is sold. The earnout agreement should address the following:
- Duration. In our experience, the typical duration runs from two to five years and often sets a performance average. For example, Year 1 may fall below expectations, but, if Year 2 exceeds expectations by a considerable margin, the earnout is applied evenly.
- Cap/Floor. Because the earnout depends on the company’s performance, it is advisable that a minimum payment be set in order to protect the seller, while a maximum might be set to protect the buyer.
- Payout Schedule. While some earnout agreements call for the seller to wait until the completion of the earnout period to receive their additional revenue or selling price, others allow for the seller to receive interim or periodic payments based on performance achieved during specified periods or upon reaching certain milestones.
- Payout Basis. In many cases, the buyer will try to base the earnout on a percentage of the company’s net profit or EBITDA, while the seller might want to base it on gross sales. Negotiations often result in a compromise, such as gross profit.
- Alternative Targets. A helpful Hartford article, “Earnouts and Contingent Payments,” notes that some earnouts are based on achievement levels or events aside from revenue or profits. Instead, a “specific event, such as the signing of particular contracts,” might satisfy the buyer’s expectations.
- Tax Treatment. Will the money that the earnout generates for the seller be treated as part of the purchase price or as ordinary income? Using a conditional seller note can keep the value as a capital gain for the seller, whereas calling it an “earnout” will typically allow the buyer to deduct the payment as a current expense against income.
- Provisions in Case of Litigation. Sellers should have provisions for security and default, and both parties should want language governing how disputes will be resolved (e.g., whether the earnout was actually earned and, if not, whether the buyer is to blame).
- Seller Involvement. Since earnouts are based on the company’s future performance, they often work best when the seller remains in control for the duration of the earnout period. This allows the seller to try to maximize performance, and it avoids potential disagreements and blame that might arise if the earnout fails to meet expectations under the buyer’s sole management.
- Maintaining the Status Quo. Because earnouts are largely based on the seller’s expectations regarding revenue, the earnout agreement might restrict the buyer from making major structural or operational changes in the business without the seller’s concurrence.
- Other Terms. Key contractual considerations might also include specifying (a) who will receive the earnout proceeds, (b) what accounting methods/principles and financial metrics are to be used, (c) whose accountant will be keeping score, and (d) how either party may audit the scorekeeper.
If you are reading this article as a potential seller, from your perspective the success of the earnout will depend on your ability to achieve the expected results. If you are staying on to run the company, you should carefully consider the following:
- Operational Control. How much autonomy and control will you actually have? Will you have the freedom to make the decisions necessary to achieve your expected results?
- Budgetary Control. Having control of the operating budget and an agreement regarding the capital budget enables you to allocate resources and make certain purchases on which the earnout’s success will depend.
- Your Team. Keeping the band together may be critical to the success of your earnout, and your agreement with the buyer should address your authority to retain, dismiss and manage key employees and hire new ones.
In a June 2021 Forbes article, “Understanding Earnouts in Mergers and Acquisitions,” the author raises some additional questions that warrant seller deliberation:
- Is the amount of the potential earnout payments significant enough to delay the seller getting all cash up front?
- Are the earnout milestone targets reasonably achievable in a reasonable time period?
- How can the seller make sure the buyer doesn’t operate the business in a way that minimizes or eliminates the earnout payments? (See “Operational Control,” above.)
- What commitments will the buyer give to support the business and optimize the likelihood that the maximum earnout will be earned?
- How can the seller protect itself from the buyer manipulating the financial metrics of the business in a way that adversely affects the earnout payments?
The Forbes article also notes that a seller might include in the earnout agreement a provision that “under certain circumstances, the maximum amount of the earnout should be accelerated and paid out early” in response to certain circumstances or events occurring during the earnout period (e.g., a total or partial sale of the business, a substantial change in the business, a breach of contract by the buyer, termination of key people, or – on the bright side – early achievement of the earnout’s milestones or objectives.
Earnouts are not a new concept. They have long constituted a powerful and, until recently, underutilized tool that can expand a deal’s potential and extend the risk and reward between buyer and seller.
Much of the underutilization of earnouts has stemmed from two sources:
- Complexity. There is little question that adding an earnout provision to your sale agreement can further muddy an already-complicated deal. However, both parties should weigh an earnout’s short-term complexity against its potential benefits and pursue the course that is likely to yield the best outcome in the long run.
- Risk. Well-meaning risk-averse attorneys, CPAs, and even some M&A professionals may advise against earnouts because of the risk that something could go wrong. Granted, excluding an earnout eliminates the earnout collection risk, but it also deprives the parties of the earnout’s upside potential. For the seller, an $11 million sale with no earnout carries less risk, but an initial $10 million with an earnout that could yield an additional $2 million might make the risk worth taking.
Far from being something for which use should be discouraged, the earnout should be seen for what it is: A powerful enabler affording both the buyer and seller maximum profitability, business value, and deal satisfaction.