What Is an Earnout?
An earnout is a contractual provision stating that the seller of a business is set to obtain additional compensation in the future if the business achieves certain financial goals, usually specified as a percentage of gross sales or earnings.
If an entrepreneur aiming to sell a business is asking for a price higher than what a buyer is willing to pay, an earnout provision can be utilized. For example, the purchase price could be $1 million plus 5% of gross sales over the next three years.
Key Takeaways
- An earnout is a contract that provides future compensation to the seller if the business meets specified financial targets.
- Earnouts resolve differing expectations between sellers and buyers by tying part of the payment to future performance.
- This mechanism reduces the buyer’s risk as they pay part of the price upfront, with the remainder depending on future business performance. Sellers benefit from potential future growth.
- Key considerations include earnout recipients, accounting assumptions, and the agreed-upon time period.
Grasp the Value of an Earnout
Earnouts don’t adhere to strict rules. The payout level depends on factors like the size of the business and can bridge differing expectations between buyers and sellers.
Earnouts mitigate buyer uncertainty by linking to future financial performance. Buyers pay a partial cost upfront, with the remaining amount based on hitting future targets. Sellers gain from the future growth of the business for some time. Financial targets like net income or revenue will often determine an earnout.
Structuring an Earnout for Success
Key considerations when structuring an earnout extend beyond cash compensation. This includes identifying crucial organizational members and determining if the earnout applies to them.
Two primary negotiation points are contract length and the role of executives post-acquisition, since these factors influence company performance. If key employees leave, meeting financial targets may be challenging.
The agreement should clarify what accounting assumptions will be utilized moving forward. While generally accepted accounting principles (GAAP) offer guidelines, managerial judgments can still impact results. For instance, assuming a high level for returns and allowances might decrease earnings.
Changes in strategy, like exiting a business or investing in growth could affect immediate results. Sellers should be aware to find equitable solutions.
Selecting the financial metrics to define the earnout must be mutually beneficial. Consider using metrics that benefit both parties, like a mix of revenues and profit metrics.
Legal and financial advisors can help navigate the process, with fees increasing based on transaction complexity.
The Benefits and Drawbacks of Earnouts
There are advantages and disadvantages for both buyers and sellers in an earnout arrangement.
Advantages for Buyers:
- Extended payment periods rather than upfront lump sums.
- Lower payouts if earnings are not as high as expected.
Advantages for Sellers:
- Potential for tax benefits by spreading income over several years.
Disadvantages for Buyers:
- Extended involvement of the seller who may want to influence business operations to ensure earnings are boosted.
Disadvantages for Sellers:
- If future earnings fall short, sellers might not receive the anticipated compensation.
Earnout in Action: An Example
ABC Company boasts $50 million in sales and $5 million in earnings. A potential buyer offers $250 million, yet the current owner thinks this undervalues future growth prospects, seeking $500 million instead. They bridge this gap using an earnout. A plausible compromise might be an upfront cash payment of $250 million with an earnout of up to $250 million contingent upon reaching $100 million in sales within three years, or $100 million if sales totalling $70 million are met.
Conclusion
Earnouts serve as a pivotal tool in bridging valuation gaps in business sales, catering to both seller and buyer interests via structured future compensation. With strategic planning and professional guidance, businesses can effectively leverage earnouts to optimize sale processes and future performance goals.
Related Terms: earnings, acquisition, gross sales.
