What Is an Earnout in a Business Sale?
An earnout is a contractual provision in a business sale where a portion of the purchase price is tied to the future performance of the business. Instead of receiving the full sale price at closing, the seller receives a percentage of the price only if the business achieves specific financial goals after the acquisition.
Earnouts show up in more business transactions than most sellers expect, particularly in the lower middle market. While they can be an effective tool to bridge the gap between a buyer's offer and a seller's asking price, they also introduce significant risk and complexity to the deal.
Why Do Buyers Propose Earnouts?
Buyers typically propose earnouts for three primary reasons:
- Bridging Valuation Gaps: When a seller believes their business is worth $5 million based on future projections, but the buyer only values it at $4 million based on historical performance, an earnout can bridge that $1 million gap.
- Risk Mitigation: Buyers use earnouts to protect themselves against a post-sale decline in revenue, especially if the business relies heavily on the departing owner's personal relationships.
- Financing the Deal: In some cases, buyers use future cash flow generated by the business to pay the earnout, reducing the amount of upfront capital they need to bring to the closing table.
The Risks for Sellers
For sellers, agreeing to an earnout means accepting that a portion of their payout is not guaranteed. The primary risk is that you lose control of the business after closing, but your final payout depends on how well the new owner runs it.
Consider these potential risks:
- The buyer might mismanage the business, causing revenues to drop and missing the earnout targets.
- The buyer might redirect resources, marketing budgets, or key personnel to other divisions of their company.
- The buyer might change accounting methods, making the business appear less profitable on paper to avoid paying the earnout.
- Integration issues or culture clashes could lead to the loss of key employees or major customers.
Structuring a Fair Earnout Agreement
If an earnout is necessary to get the deal done, it must be structured carefully to protect your interests. A well-structured earnout requires precise legal language and clear definitions.
Keep It Simple and Measurable
The metrics used to calculate the earnout must be objective, easily measurable, and difficult to manipulate. Complex formulas invite disputes and litigation.
Define Operational Control
The agreement should include covenants that require the buyer to operate the business in the ordinary course, maintain adequate funding, and not intentionally sabotage the earnout targets.
Set a Reasonable Timeframe
Most earnouts run for one to three years. The longer the earnout period, the more risk the seller assumes. Try to keep the timeframe as short as possible.
Include Audit Rights
Sellers must have the right to review the buyer's financial records and challenge the earnout calculation if they believe it is inaccurate.
Common Metrics Used in Earnouts
The metric chosen to measure performance is the most critical component of the earnout agreement.
- Top-Line Revenue: This is generally the safest metric for sellers because it is difficult for a buyer to manipulate through accounting practices.
- Gross Profit: A middle-ground metric that protects the buyer from a seller "buying" revenue through deep discounts, while still protecting the seller from the buyer's overhead expenses.
- EBITDA or Net Income: This is the most dangerous metric for sellers. Buyers can easily load the business with new corporate overhead, management fees, or aggressive depreciation, wiping out paper profits and the earnout payout.
Alternatives to Earnouts
Before agreeing to an earnout, consider whether alternative deal structures might achieve the same goals with less risk:
- Seller Financing: A promissory note provides the buyer with financing assistance but gives the seller a guaranteed payout with interest, secured by the assets of the business.
- Retained Equity: Rolling over a portion of your equity allows you to participate in the future upside of the business without the strict performance targets of an earnout.
- Consulting Agreements: A fixed consulting agreement guarantees a set income for your transition assistance, regardless of the company's financial performance.
Conclusion
While earnouts can be a valuable tool for bridging valuation gaps and getting a deal across the finish line, they require careful negotiation and precise structuring. Never agree to an earnout without the guidance of an experienced M&A advisor and transaction attorney who can help you navigate the risks and protect your hard-earned equity.
