An earnout, a potent tool in negotiating a business’s purchase price, serves as a bridge between the buyer’s willingness to pay and the seller’s price expectations.
One of the common obstacles in structuring a business sale arises from differing perceptions of value. Sellers often envision the highest profit potential, whereas buyers tend to focus on risks and past earnings. Sellers emphasize recent company performance, while buyers consider the average performance over previous years. This disparity can hinder the buyer’s comfort and protection while impeding the seller’s profit goals.
The Concept of Earnout
When an impasse emerges, an earnout can mitigate the value gap between buyer and seller. Earnouts entail a predetermined future sum that the buyer commits to pay the seller based on post-transaction business performance.
To put it differently, 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 practical terms, during business purchase negotiations, the buyer might express their position as follows:
“Mr. Seller, you value your business at $50 million, but we’re uncertain about that. We believe it’s currently valued at $40 million. How about we pay you $40 million now, and the remaining $10 million will be contingent on earnings over the next three years if we attain an EBITDA of (fill in the blank)?”
Naturally, an actual earnout agreement would entail more detail, but the essence is apparent. Earnouts can assume various structures and be based on different financial benchmarks, such as revenues, gross profits, or net income. (Refer to “Terms” below.)
- In a typical earnout arrangement, both parties stand to gain significantly.
- The deal is completed, and the business is sold.
- The earnout offers potential maximum value to the seller without escalating risk for the buyer.
- The buyer acquires the business at a lower immediate cost, and the seller has an opportunity to recover the difference in the future.
- During periods of high interest rates, an earnout can help offset the gap caused by debt coverage.
If the seller remains actively involved, their continued presence (along with their knowledge, skills, reputation, customer retention, and profit motivation) enhances the likelihood of meeting earnout targets, benefiting both the seller and the buyer.
Additional benefits are more skewed toward the buyer. For instance, if the business faces customer concentration issues, an earnout can safeguard the buyer by linking the sales price to client retention. Similarly, if the company being acquired is a professional practice, the buyer might require assurance that the seller’s clients or patients will remain, making an earnout an effective mechanism for transferring relationships and ensuring payments are tied to retained clients/patients.
The language and structure of the earnout should be clearly defined at the time of the business sale. The earnout agreement should address the following:
- Duration: Typically spanning two to five years with a performance average. For instance, if Year 1 underperforms but Year 2 exceeds expectations significantly, the earnout is applied proportionately.
- Cap/Floor: To safeguard the seller, a minimum payment is advisable, while a maximum might be set to protect the buyer, as the earnout hinges on company performance.
- Payout Schedule: Some earnout agreements stipulate interim or periodic payments based on achieved performance during specified periods or milestone achievements, rather than waiting until the end of the earnout period.
- Payout Basis: Negotiations often lead to compromises, such as basing the earnout on gross profit when the buyer prefers net profit or EBITDA.
- Alternative Targets: Earnouts can be linked to achievements beyond revenue or profits, such as signing specific contracts, to fulfill the buyer’s expectations.
- Tax Treatment: Structuring the earnout as a conditional seller note can yield capital gains for the seller, while classifying it as an “earnout” typically allows the buyer to deduct the payment as an expense.
- Provisions for Litigation: Provisions for security, default, and dispute resolution should be included, addressing whether the earnout was truly earned and assigning responsibility if it wasn’t.
- Seller Involvement: When the seller remains in control during the earnout period, it can maximize performance and prevent disputes that might arise if the earnout falls short under the buyer’s sole management.
- Maintaining Status Quo: The earnout agreement might restrict major operational changes without the seller’s agreement, as it’s closely tied to revenue expectations.
- Other Terms: Details like who receives the earnout proceeds, the accounting methods and metrics used, scorekeeping by accountants, and audit provisions can be specified.
If you’re a potential seller, the earnout’s success hinges on achieving the anticipated results. If you’re staying to manage the company, ponder the following:
- Operational Control: Assess the degree of autonomy you’ll possess and whether you can make decisions necessary for success.
- Budgetary Control: Having control over operating and capital budgets allows resource allocation crucial for earnout success.
- Your Team: Retaining key employees and making new hires can be vital for earnout success. Your agreement should outline your authority in managing the team.
In a Forbes article, “Understanding Earnouts in Mergers and Acquisitions,” the author suggests additional questions for sellers to contemplate:
- Is the potential earnout significant enough to offset delayed full cash payment?
- Are the earnout milestones achievable within a reasonable timeframe?
- How can you ensure the buyer doesn’t undermine earnout payments through their operations?
- What commitments will the buyer make to support the business and maximize earnout potential?
- How can you guard against manipulation of financial metrics that could affect earnout payments?
The article also proposes that sellers might include a provision accelerating the maximum earnout payment under specific circumstances or events during the earnout period.
Earnouts aren’t novel; they have long served as a potent yet underutilized tool, enriching a deal’s potential and sharing risk and reward between buyer and seller.
The underutilization of earnouts often originates from:
- Complexity: While adding an earnout provision can complicate an already intricate deal, both parties should weigh its short-term complexity against long-term benefits.
- Risk: Advisors may discourage earnouts due to potential risks, but excluding them eliminates both collection risk and upside potential. Sellers should assess whether the risk is worth the potential reward.
The earnout is a potent enabler that maximizes profitability, business value, and deal satisfaction for both buyer and seller.
Preparing your business for sale is an important part of your business. If you would like to discuss the value of your business, please book a complimentary call with any of our senior M&A Advisors.
*This article originally appeared on IBG Foxfin site.