When it’s time to sell your business, you’ll quickly find that there are many deal structures available. The business broker in charge of your merger and acquisition (M&A) deal will work to find the deal that best suits your goals and intentions, both personal and professional.
One option that may be presented to you is an earnout, which brings up the question: What is an earnout? This strategy is typically employed if there’s a valuation gap between the buyer and the seller, meaning the seller thinks the business is worth considerably more than what the buyer is offering.
In this article, you’ll learn everything you need to know about earnouts and how they relate to the sale of a business. Specifically, you’ll learn how earnouts work and the pros and cons associated with them.
What Is an Earnout?
If you’re looking to sell your business, you likely have an idea of what you think your company is worth. However, an owner’s perception and the market value don’t always meet eye to eye. Sellers often think that their business is worth more than it actually is. This phenomenon, known as the valuation gap, derails — or, at the very least, slows down — M&A deals all too often.
This is where earnouts come into play. Earnouts are one option to help fill the valuation gap and keep deals moving. An earnout allows sellers to overcome the valuation gap by leveraging expected future performance. If an earnout is agreed to, a time period and benchmark targets will be established.
The time period is often referred to as an earnout period. The benchmarks are typically financial targets tied to sales and earnings. If the business achieves these agreed-upon milestones, the seller will receive an earnout payment.
Earnouts are most notably associated with small businesses or startups in growth mode, which can be a win-win for both buyers and sellers in an M&A transaction. An earnout allows buyers to ensure that the business does indeed grow over a specified period of time. It also allows sellers to capitalize on expected future performance and maximize their potential earnings from the sale.
How Does an Earnout Work?
As mentioned, earnouts work by filling the valuation gap. In a sense, they allow the seller to “put their money where their mouth is.”
Let’s say, for instance, that a seller thinks their business is worth $3.5 million. However, upon going to market, they are only getting offers closer to $3 million. There’s a buyer who is very interested in the business, but this potential new owner is concerned about overpaying for the company.
The buyer and seller work out a deal to pay $3 million upfront for the company. There are then performance targets enumerated in the purchase agreement. For example, the buyer and seller agree to a payout of 5% of gross sales for the next three years. As the seller, your financial models indicate expected gross sales of $3 million, $3.5 million, and $4 million over the next three years. If you were to earn 5% of this, your earnout payouts would be:
- $3 million x 5% = $150,000
- $3.5 million x 5% = $175,000
- $4 million x 5% = $200,000
Your total earnings from the earnout agreement would be $525,000. Not only would this cover the valuation gap, but you’d earn more than what you had originally expected to get from the sale.
Brokers can use an array of financial metrics to craft an earnout provision. Examples include, but are not limited to:
- Net/gross sales
- Net/gross revenue
- Net/gross profit
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Net income
- Other cash flow metrics
Though the period of time for the earnout period is negotiable, they typically last for one to three years after the sale.
A large portion of the Definitive Agreement will outline how and when the seller will receive payments on the earnout. Both buyer and seller must ensure that this is as detailed as possible so that everyone has a clear understanding of whether or not a target has been achieved after the sale.
For instance, in the example above — what is the definition of gross sales? What if the new owner changes the structure of the business and gets rid of certain products? What if the acquired company is resold, especially in an asset sale? Are there stipulations regarding the retention of key employees? These issues should be flushed out beforehand so that there are no gray areas post-closing.
What Are the Upsides of an Earnout?
Earnouts can be advantageous to both buyers and sellers. There’s minimal risk associated with the deal for buyers, especially when considering that the buyer likely has done their due diligence before the sale and has an understanding of potential future earnings.
Buyers are able to agree to a purchase price. They likely would have agreed to this price one way or the other. Earnout payments are a minimal extra compared to potential earnings. In a nutshell — if the buyer has to make earnout payments, it means the business is growing and there’s a good chance that the sale is successful.
Earnouts can also be advantageous to sellers because it allows them to overcome the valuation gap. If a seller truly believes that their business will continue to grow after the sale, then working an earnout agreement into the deal structure would allow them to capitalize on that potential.
What Are the Downsides of an Earnout?
Should a seller agree to an earnout agreement, it essentially forces them to “put their money where their mouth is.” Sellers need to be confident that:
- The business is in a position to achieve future growth
- The buyer will be able to deliver this growth
- The valuation gap is valid and a concern for both sides
- The Definitive Agreement spells out all details thoroughly
Earnouts can be a double-edged sword for sellers, but they can be a win-win if used in the right circumstances. Some earnout stipulations may require former owners to stay involved with the business to help ensure financial targets are met. If you’re an owner looking to get out of the business completely, this stipulation could complicate the deal.
Consider All Options When Selling Your Business
Every seller wants to get as much money as possible when selling their business. But the selling process often yields valuation gaps, which can be frustrating and challenging to overcome. However, one tool that can be used to overcome them is an earnout.
What is an earnout? Simply put, an earnout is an agreement between the buyer and the seller to future payouts. These payouts are typically defined by financial metrics. Earnouts are typically seen in the sale of growth companies. They can be advantageous to both buyers and sellers, though sellers are taking on a bit more risk.
Agreeing to, and clearly defining, earnout provisions can be daunting. That’s one reason why it’s important to hire trusted brokers when negotiating your deal. If you’re looking for a trusted team of M&A advisors to help you with the sale of your business, be sure to reach out to the team at Allan Taylor and Company.