In most scenarios, the sale of a business entity is completed once the owner signs an agreement and is paid by the buyer. However, there are cases when a deal cannot be completed because of a disagreement regarding the price. When neither party agrees to the proposed terms, a strategy may be used to allow the agreement to progress. This strategy is called an earnout. With an earnout, the buyer gets to purchase the business and the seller is paid, but with a provision for future compensation.
What is an Earnout?
An earnout is a payment made by the buyer to the seller of a business entity when certain performance targets or financial goals are achieved. Earnouts are often computed as a percentage of the earnings or gross sales.
Earnouts are usually included as a provision in the sale agreement if the buyer cannot or is not willing to pay the owner’s asking price. For example, if the owner is selling the business at $2 million but the buyer is only willing to pay $1.5 million, the buyer may offer to purchase the company at that price plus, say, 5% of the gross sales in the next two or three years.
Earnouts … Do They Work?
Earnouts could be an effective and profitable solution for both business owners and buyers, provided that risks are assessed thoroughly. The usual perception is that the buyer takes on risks associated with buying the business. However, there are also certain concerns that the seller takes responsibility for.
An earnout is dependent upon the performance of the business post-sale – operational-, financial-, and/or milestone-wise. Metrics are already set and agreed upon but will depend on particular situations. If, for example, the buyer intends to integrate the new business into an existing business, the metrics will usually be based on revenue. If, on the other hand, the revenue performance of the new business is untested and therefore uncertain, the metrics will be based on profit. In most cases, a seller will prefer the earnout to be revenue-based while a buyer would prefer it to be profit-based, mainly as protection against uncertainty.
There are also potential differences regarding the management and operational preferences of the buyer and the seller. For example, the seller might think that the business will basically operate in the same way after its sale while the buyer might want to implement changes such as the discontinuation of certain products and imposing movement in the ranks of key employees.
However, earnouts can be a means for a business owner to profit from the sale of his/her business. An earnout can also provide the buyer with a way to finance a business or purchase it at a more affordable price. It also stretches out the paying period for the buyer, which gives him/her plenty of room to move financially. The seller, on the other hand, enjoys continuous income throughout the earnout period.
Is an Earnout the Right Option for You?
Earnouts are quite challenging because they are considered the most difficult concept in mergers and acquisitions to design and execute. They require intricate and thorough assessment and anticipation of benefits and issues, and reasonable prediction of present and future circumstances. An earnout is a strategy and must be viewed as a tool that can be applied to growing an existing business. However, it can only work if both the buyer and seller consider the risks and potential issues and anticipate these with the right solutions in place. With good flexibility in plan design and implementation, any issue or risk can be managed successfully.
Earnouts, like many facets of a business, are never easy. MergersCorp M&A International understands the challenges that business owners and companies face. We believe in adding value to every transaction by helping our clients buy and sell private businesses confidently. Our global reach allows us to provide a service that creates strong companies that will thrive in the most competitive industries.