Earnout: Definition, How It Works, Example, Pros and Cons

What Is an Earnout?

An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings.

If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1 million plus 5% of gross sales over the next three years.

Understanding an Earnout

Earnouts do not come with hard and fast rules. Instead, the payout level is dependent on a number of factors, including the size of the business. This can be used to bridge the gap between differing expectations from the buyers and sellers.

An earnout helps eliminate uncertainty for the buyer, as it is tied to future financial performance. The buyer pays a portion of the cost of the business upfront, and the remainder of the cost is dependent upon if future performance targets are met. The seller also receives the benefits of future growth for a period of time. Different financial targets such as net income or revenue may help determine earnouts.

Structuring an Earnout

There are a number of key considerations, aside from the cash compensation when structuring an earnout. This includes determining the crucial members of the organization and whether an earnout is extended to them.

The length of the contract and the executive's role with the company post-acquisition are two issues that also have to be negotiated. This is so because the performance of the company is tied to management as well as other key employees. If these employees leave then the company may not hit its financial targets.

The agreement should also specify the accounting assumptions that will be used going forward. Although a company can adhere to generally accepted accounting principles (GAAP), there are still judgments managers have to make that can affect results. For instance, assuming a higher level for returns and allowances will lower earnings.

A change in strategy, such as a decision to exit a business or invest in growth initiatives may depress current results. The seller should be aware of this in order to come up with an equitable solution.

The financial metrics used to determine the earnout must also be decided upon. Some metrics benefit the buyer while some benefit the seller. It is a good idea to use a combination of metrics, such as revenues and profit metrics.

There are legal and financial advisors that can assist with the entire process. The fee for advisors typically grows with the complexity of the transaction.

Advantages and Disadvantages of an Earnout

There are both advantages and disadvantages for the buyer and seller in an earnout. For the buyer, an advantage is having a longer period of time to pay for the business rather than all upfront. In addition, if earnings are not as high as expected, the buyer does not have to pay as much. For the seller, the advantage is the ability to spread out taxes over a few years, helping to reduce the tax impact of the sale.

A disadvantage to the buyer is that the seller may be involved in the business for a longer period of time, wanting to provide assistance to boost earnings or use their previous experience to run the business how they see fit. The disadvantage to the seller is that the future earnings are not high enough, therefore, they do not make as much from the sale of the business.

Example of an Earnout

ABC Company has $50 million in sales and $5 million in earnings. A potential buyer is willing to pay $250 million, but the current owner believes this undervalues the future growth prospects and asks for $500 million. To bridge the gap, the two parties can use an earnout. A compromise might be for an upfront cash payment of $250 million and an earnout of $250 million if sales and earnings reach $100 million within a three-year window or $100 million if sales only reach $70 million.