An earnout generally refers to purchase consideration received that is based on the future performance of the company.
An earnout is additional compensation paid to the seller of a business after the transaction is completed. It is standard for the payments to be dependent on specific terms and conditions being met by the business as it operates in the years following the sale. For example, the payment might be contingent on the business reaching a certain revenue level each year.
One reason earnout payments exist is due to a gap between what a buyer is willing to pay and what a seller is willing to accept. Earnouts can bridge the valuation gap in order to complete the sale. These payments can serve to protect buyers from overly rosy projections of business performance because they are typically contingent on revenue or profitability. They also serve to compensate sellers who expect their businesses to perform strongly in the future, but face skepticism from buyers.
Another common reason for earnouts is with businesses that have high customer concentration. Buyers are often fearful of losing the customers that make up a large portion of the business. Earnouts are able to make deals more feasible for businesses with customer concentration.
As a seller, consider that when you say or think the following, it likely means earn-out, “This business has so much potential. If a buyer just focuses on x they will grow it so much. That needs to be factored into the sale.”
Similar to seller financing, earnouts allow the buyer to pay a lower amount at closing, with expected payments over a period of time. Earnouts, however, are less likely to be guaranteed (because they are contingent upon business performance) and almost never accrue interest.
Earnout agreements may be used to entice the seller to remain involved with the business after the sale. This provides incentive to the seller to make sure performance hurdles are reached in order to receive their compensation. It also allows the buyer a longer transition period to become accustomed with running the business.
Earnouts should primarily be considered when the business will be operated similarly after the sale as it was before the transaction. This makes it easier to project future performance and there will be less difficulty determining the performance contingency. If the buyer plans dramatic shifts in operations, earnouts may not make sense in the deal structure.
Sellers generally do not want earnouts to be included in the deal structure. Why? Because it often means less cash will be paid at closing. The seller also loses a level of control whether the earnout payments will be paid or not. Since the seller isn’t running the business after the sale, they will need to trust the buyer to run the business in a way that reaches the performance hurdle required to trigger the earnout payments.
Finally, earnout payments are generally a small part of the total purchase price (typically less than 10%). While small, earnouts can be useful options to keep a deal together when other negotiations stall.