Back in January 2023 we wrote a short article explaining earnouts entitled Resolving Valuation Deadlocks in M&A: The Strategic Role of Earnouts HERE>. Now, let’s dig in a little more detail on earnouts to cap out 2024!
Many business sellers are hesitant to consider earnouts, often believing they will earn less money and face delays in receiving payment. However, understanding the mechanics of earnouts can empower sellers to close deals faster and potentially earn more. Here’s how earnouts work and why they may be a beneficial option.
Purchase Price: Fixed or Variable?
The purchase price is the amount agreed upon for a business sale. Sellers can receive this price through various means, including cash, seller financing, stock, or a combination of these. The purchase price can either be fixed or variable:
- Fixed Price: A static amount, unaffected by future performance.
- Variable Price: Dependent on post-sale metrics, which introduces the concept of an earnout.
A fixed purchase price remains unchanged regardless of the business’s performance post-sale. For example, if a business is sold for $10 million with a fixed price, the buyer pays $10 million.
In contrast, a variable purchase price adjusts based on agreed-upon performance metrics. For instance, the seller might receive $1.5 million upfront, with additional compensation tied to achieving specific milestones.
What Is an Earnout?
An earnout ties part of the seller’s compensation to the business achieving certain post-closing performance metrics. For example, the agreement may stipulate that the seller receives additional compensation if the business grosses $2.5 million in sales within its first year under new ownership.
Common performance metrics include:
- Seller’s Discretionary Earnings (SDE)
- Revenue growth
- Customer retention
Earnouts often involve multiple metrics. For instance, the seller might receive additional compensation for both retaining a key client and achieving a specific annual revenue increase.
Why Do Earnouts Occur?
Earnouts are primarily about sharing performance risk. Sellers typically prefer receiving all their compensation upfront, while buyers, assuming post-sale risks, may hesitate to commit to a large fixed price.
For example, a buyer might value a business at $15 million rather than $20 million due to risks such as dependency on a key customer or reliance on the owner’s charisma. An earnout bridges this gap, offering buyers reassurance and motivating sellers to ensure the business’s continued success. So the purchase price is $15 million with an additional $5 million to be “earned out” should the new owner hit defined metrics over a period of time.
Advantages of Earnouts for Sellers and Buyers
Earnouts can lead to higher overall compensation because sellers share the risk. Buyers may agree to a higher total purchase price since the seller assumes some of the post-closing uncertainties. In a competitive market, this can enable sellers to command a premium. Additionally, earnouts can attract buyers when a business struggles to generate interest. For stagnant listings, offering an earnout may incentivize potential buyers to explore and ultimately purchase the business.
Buyers like earnouts for the opposite reason: it reduces their risk profile for the acquired business and insulates them from something they missed in due diligence that affects performance or perhaps a coming market shift that they can’t currently predict.
Risks Associated with Earnouts
While earnouts can benefit sellers, they also carry risks, particularly around business control and performance under new ownership.
Selling to an Individual Buyer
If the seller doesn’t remain involved post-sale, the business’s performance might suffer under the new owner. Even experienced buyers may face challenges adapting to an unfamiliar business, staff, or market.
Selling to a Larger Business
Selling to a larger company introduces additional risks. The acquiring company may prioritize its corporate interests over the seller’s earnout conditions. Examples include:
- Dividing the smaller business into segments
- Relocating operations
- Imposing costly corporate expenses
- Absorbing the smaller business into its overhead
These changes could impact the seller’s ability to meet performance metrics, reducing their payout.
Protecting the Seller’s Interests
Earnout agreements should address key areas to safeguard the seller’s compensation:
Premature Termination
The agreement should specify that early termination of the seller’s employment triggers full payout of the earnout. It should also prohibit termination for unjust reasons.
Expense Protection
The seller should limit corporate expenses charged to the business post-sale, as excessive costs could hinder performance and reduce the earnout payout.
Business Control
To ensure fair treatment, the agreement should include provisions granting the seller input on key decisions that impact performance metrics. For example:
“If the buyer takes actions, or fails to take action, that could materially impede performance within a 12 month period without consulting seller, then the seller retains the right to claim the full earnout.”
The Importance of Details
The success of an earnout often hinges on carefully negotiated terms. Sellers must ensure the agreement provides sufficient control and protections to maximize the likelihood of achieving earnout milestones.
Earnouts don’t have to be intimidating. By understanding how they work, sellers can leverage earnouts as a strategic tool to close deals more quickly and secure higher compensation. With proper planning and negotiation, earnouts can transform reluctance into opportunity.
