What Is an Earnout? (With Advantages and Disadvantages)
By Indeed Editorial Team
Published June 9, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
A business sale is a complicated transaction procedure that involves several negotiations, agreements, and exchanges of vast sums of money. A good way buyers finance the purchase of a business is through an earnout. Understanding the concept of earnout can help you learn the best processes involved in finalizing a business sale or purchase. In this article, we learn the answer to the question "What are earnouts?" provide its structure, discuss its pros and cons to sellers and buyers, and highlight earnout examples.
What is an earnout?
If you have an interest in business sales, you might be wondering, "What is an earnout?" An earnout is a payment a seller receives from the buyer of their business after the business agrees on set performance objectives. It occurs when the purchaser pays an initial deposit of the business' value and offers compensation to the seller, depending on the company's subsequence success. The parties to the business transaction determine the earnout payments, depending on the business' sales and earnings.
The business seller typically collects a set percentage of business sales and earnings if the company surpasses set targets. For instance, business owners can sell their company for $800,000 million, plus 5% of sales over the next seven years. The business owner is funding the buyer's purchase of the company. The more successful the business is, the more money the seller can earn, and the quicker the buyer can pay the loan. You can find earnouts and their details in a company's sales contract. Reasons why buyers and sellers may agree to earnouts are:
The purchaser may not afford to pay the business' total value upfront.
The buyer and seller can't agree on a set price.
A startup business has a low market value but has major future earnings prospects.
Why are earnouts important?
Earnouts are contractual provisions indicating that a business owner is ready to sell the business and receive future compensations in the event of the business' success. An earnout resolves the varying opinions of both parties to the transaction. It removes uncertainties for the buyer, as they only pay a deposit upfront and pay the rest according to the business' subsequent performance. It also eliminates uncertainties for the seller as there's hope for the business' growth. There are legal and financial experts to help with the transaction procedure. The fee for these consultants depends solely on the transaction's complexities.
The negotiations also depend on the seller, executives, and employees' roles in the industry after the sale of the company and whether other parties receive compensations from the earnouts. These considerations help bridge the gap between differing expectations from the buyers and sellers.
Structuring an earnout
There are many vital things to consider besides cash compensation when structuring an earnout. Below are some crucial factors to consider when structuring an earnout:
Earnout recipients: In the sale of a business, it's crucial to specify the recipients of the earnout compensation. Determine the critical members of the sold company, such as board members, executives, and employees and confirm what parties can receive compensation from the earnout.
Duration of the contract: The contract's duration and the executive members' role with the business post-acquisition are two issues to negotiate when structuring an earnout. As managers and critical employees determine the performance of the business, it's essential to complete the contract while they remain in the company to achieve the company's financial goals.
Accounting assumptions used: It's necessary for the agreement to specify the accounting assumptions to use when structuring. Although a company can use generally accepted accounting principles, there are still decisions required by managers to make which could affect the transaction's outcome.
A change in strategy: Modifying an effective business strategy like a business exit or a new investment may affect results. It's vital for the seller to be aware of such changes timely and create an appropriate remedy.
Financial metrics: It's essential to decide on the financial metrics used to determine the earnout. As some metrics can particularly favour the buyer or the seller, it's best to combine several metrics, such as revenues and profit metrics, for a fair business transaction.
Advantages of earnouts
Earnouts can benefit both the buyer and seller of a company. It's crucial to structure earnouts equitably and fairly to benefit both parties. Below are some advantages of earnouts for buyers:
Reduced doubt: The buyer has less uncertainty about their investment because the total amount they pay depends on the company's performance. If the business isn't as successful as they anticipated, they pay a lower total amount.
More time to pay: Earnout agreements allow a long-term payment plan for the buyers to complete payment. As buyers have a longer time to pay for the company's purchase, it's financially profitable.
Smaller upfront payment: An earnout involves the buyer making a part payment upfront for a company. The initial purchase price is often more manageable for the buyer than paying for the company's total market value.
Advantages of earnouts for sellers include:
Steady income: The seller receives earnout payments for an extended period. It provides them with an additional source of earnings and a continued source of income.
Smaller tax payments: Because the company's sale spreads over several years, the amount of taxes the seller owes on it spreads out, as well. It eases the financial burden on the sellers.
An incentive for success: As the buyer benefits from the company's success, they have an incentive to keep the company reputable and performing well. While some sellers can also remain employees in the business, the hope of higher compensation drives them to be more productive.
Disadvantages of earnouts
Earnouts do have a few disadvantages, depending on the company's performance and the contract details.
Potential disadvantages for buyers include:
Seller's involvement: Because the seller continues to have a financial interest in the business, they might try to help or advise the buyer. For this reason, many earnout agreements include a specification that says the seller cannot be involved with the business after a certain period.
Low earnings: If the company's profits aren't high enough, the buyer might not be able to pay off the company as quickly, if at all. Many earnout agreements include conditions that protect the buyer from bankruptcy if this scenario occurs.
Potential disadvantages for sellers include:
Continued involvement with the company: Because they still have a financial interest in the company, the seller might feel obligated to monitor and participate in its success. It can be time-consuming and demanding for the selling party.
Less money earned: The more successful the company is, the more compensation the sellers receive, and vice versa. If the company's profits or sales do not reach a certain level, the seller makes less money from the company's sales.
Complexities: Earnout agreements also require critical details about every term and condition. If written poorly, they can confuse both buyer and selling and possibly result in misunderstandings.
Buyers and sellers create earnout agreements customizable to their company's size, type, and individual goals. Below are some examples of possible earnouts:
Below is an example of a business earnout:
A company has $80 million in sales and $9 million in earnings. A buyer offers the company owner $350 million for the company, but the owner believes the company is worth $600 million. They compromise by agreeing to an earnout that allows the buyer to pay $350 million upfront, plus an additional $250 million if sales surpass $100 million within six years. If the sales don't reach that amount within six years, the buyer only pays an additional $150 million. If sales fall below $80 million within six years, the buyer doesn't pay any earnout.
Below is an example of a business earnout:
A seller prices their company at $70 million, but a buyer can only pay $55 million. Because the company's fair market value is $80 million, the seller offers to finance the remaining amount so the buyer can afford to buy the business. The seller essentially loans the buyer $25 million for the buyer to pay back over six years based on the company's earnings.
The seller sets a minimum earnings percentage for each year of a six-year loan. In the first year, the seller wants the buyer to pay a minimum of 10% of EBITDA, which can be no less than $5 million. In the second year, the seller wants the buyer to pay a minimum of 20% EBITDA, no less than $10 million. The minimum payment increases each year until the buyer pays for the company.
Below is an example of a business earnout:
KKB Company has $60 million in sales and $6 million in earnings. A potential buyer wants to pay $300 million, but the current owner feels it undervalues the future growth prospects of the business and asks for $550 million. To reach an agreement, the two parties use an earnout. The earnout agreement requires the buyer to make an upfront cash payment of $300 million and an earnout of $250 million if sales and earnings reach $150 million within a five-year window or $90 million if sales fall below $100 million.
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