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If you’re selling a business and can’t find buyers willing to purchase the asset at a price you think is fair, or a buyer who thinks the seller may have not seen all the risk involved with a transaction, there are tools available where a fair deal for both sides may exist. An earnout can structure a transaction so that sellers and buyers can agree on a price and tie some of that price to a certain metric or performance of the business after the sale. This is key in negotiating and can even play into a buyers advantage if done well.
What is an Earnout?
An earnout is a deal structure in which the buyer and seller agree that based on the future performance of a business the seller will receive additional money from the buyer.
Whether the purchase is backed by investor funds, a business acquisition loan, or owner funds does not involve the earnout; this is a performance based purchase price structure for a transaction.
How Does an Earnout Work?
During the purchase of a business, the buyer and seller will agree to an earnout deal structure, where if some metric is achieved by a specific date, the buyer agrees to pay the seller an additional predetermined amount for the sale.
Why Do Companies Use Earnouts?
Earnouts are a great tool for buyers and sellers to negotiate into an agreement where both parties agree to get a deal done at a price that works for both slides. An earnout creates the space between a buyer's purchase price and a seller floor where parties can agree on certain future events to come to an agreement when the sales price and purchase price are not originally met.
Who Should Consider an Earnout?
Earnouts can be seen as less risky for a buyer; they will be able to offer only a certain amount for the sale of a business, and only be obligated to pay over that amount if a performance is met in the future. This might mean that a buyer will never need to pay anything over what has already been put down, or if the performance is met the buyer may gain confidence of the asset purchase and while paying more money to the seller, gain the positive outlook on the business given its ability to operate in a positive manner.
Is There an Earnout Payment Formula?
No, there isn’t a specific formula, an earnout can be tied to any measure the buyer and seller agree to. For example this could mean a certain number of units sold, an amount of revenue generated, or even number of downloads of a software. Because each business is different there may be different attributes the buyers and sellers would like to measure.
Example of an Earnout
Let's say that a seller agrees to sell a business to a buyer for $100,000. The buyer counters with $90,000 but will pay an additional $10,000 if a certain number of units are sold within the first year. This would represent an earnout agreement.
Another example might be the sale of a phone app where the seller and buyer agree that within the next one year the amount of downloads will increase 50% from the sale date, and if met the seller receives an additional $25,000. If this performance is met, the buyer would pay the seller the additional money on the date agreed upon.
Pros and Cons of Earnouts
Lets cover some of the advantages and disadvantages of earnouts, both for the buyer and the seller.
- For the Buyer: Reduce the risk of assuming an asset by only paying a portion of what its potentially worth, and paying the remaining only if the operation meets a certain criteria. This means buyers may get a discount, or proof of operations before paying the full price.
- For the Seller: Possible to exceed expectations and get more money for the sale of an asset by building in performance based metrics into the deal.
- For the Buyer: Possibility to payout more than required for the sale of an asset if performance is met. Another drawback is possibly creating a scenario where the owner needs to monitor metrics which were not fully monitored in the past.
- For the Seller: Lengthy paperwork and legal documentation needed to put in place a contract where performance is involved, increasing the cost of sale to the seller. Chance that earnout is not achieved and assets are sold at a discount.
When to Use an Earnout
An earnout is at the discretion of the buyer and seller of a business or other asset but a few scenarios where it may make sense can be found below.
- Buyer and seller cannot agree on price - using an earnout may allow the bridge to be created between asking and bidding price, an arrangement that would close the deal.
- Seller doesn’t want to sell - If the seller is hesitant on selling a buyer could use an earnout to grant a certain portion of sales of income over a set amount of time to entice them to sell.
- Buyer wants proof of concept - It is possible the buyer is not as certain about the operations of a business being purchased, and wants to mitigate some risk of its future operation with the seller.
What Factors Determine if an Earnout Should Be Used?
An earnout is typically used as a tool by a buyer or seller to move the deal forward in conversations, whether to purchase at a discount, entice an owner to sell, or prove the operations of a business will work for a buyer. These factors are up to the parties involved in the transaction.
When Should an Earnout Not Be Used?
It may not make sense to use an earnout if you are a seller and your future performance is at the hands of someone who may not be able to get the job done. This could be a less experienced owner, someone who doesn’t know the software, or someone with a reputation for losing employee trust.
Because the seller is accepting risk in a buyer's ability to perform an earnout may not make sense if the wheel is being handed to a buyer they do not trust.
What To Look for in an Earnout Agreement
Earnouts are typically legal documents which should be drafted and reviewed by legal experts. While each earnout agreement is different there are a few items which you should expect to see:
- Financial metrics to be used if being used
- Non-financial metrics if being used
- Time period for the earnout deal
- How the payments are structured, whether it's all or nothing, or if the seller can expect some minimum
- Minimum and maximum payments if payment varies
- Accounting standard used to measure any metrics
Exploring Earnouts: Additional Information You Need to Know
What Is the Primary Objective of an Earnout?
Allowing a buyer and seller to reach an agreement on the sale of an asset when an initial agreement may not have been met.
How Do You Calculate the Amount an Earnout Should Be?
Each earnout structure is different and requires the buyer and seller to work together to determine how to calculate the earnout and at what amount.
How Is An Earnout Documented?
An earnout should be documented by a legal professional as a contract that is enforceable.
Earnouts can be useful tools for buyers and sellers; whether to purchase at a discount or ensure operational success before paying a full amount, buyers can expect a strong benefit from earnouts. For sellers this may be seen as taking more risk on, but if unloading an asset which no buyers are willing to purchase, an earnout offers an option to clawback some money in a sale by skillfully structuring a contract which will offer sellers more compensation.