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Should I consider an earnout when selling my business?

Question

Should I consider an earnout when selling my business?


 

Answer

In the complex world of buying and selling a business, coming to an agreement on the proper price for a business can be difficult. An earnout is one element that may be a factor, but it is a complex element. Earnouts are difficult to administer and are prone to litigation. You should give careful consideration to an earnout before you agree to one.


What is an Earnout?

An earnout is a useful tool in mergers & acquisitions and is commonly used by businesses in a variety of industries. An earnout is an arrangement where the buyer pays the seller additional money based on some metric, such as if the business performs well after the closing. Earnouts are a useful way to bridge a price gap between the perceived value of a business between the buyer and the seller.

Price gaps are common in mergers & acquisitions. The seller, who may be emotionally invested in their business, often believes the business should be valued higher than what the buyer believes the business is currently worth. Earnouts are also commonly used when there is a disagreement about the expected future growth of the business and not just its present value.

An earnout essentially means the seller must earn part of the purchase price based on the future performance of the business, or some other metric. Part of the purchase price is paid at closing and the remainder is paid after the closing, with the final amount to be paid based on the future performance of the business, or some other metric.


How do Earnouts Work?

The typical term of an earnout is one to three years at approximately 10% to 25% of the purchase price. Earnouts are popular with private equity groups that do not always have the expertise to run a business and want to keep the owner incentivized following the closing.

For example, if a seller thinks their business is worth $5 million and the buyer thinks it is worth $4 million, they could settle on an initial price of $4 million, and the $1 million difference would be structured as an earnout, which would only be paid to the seller if the business performs well.


Why are Earnouts Used?

Earnouts are most commonly used to bridge price gaps.

What is the value of a business? That depends on who you ask.

  • Ask buyers what the value is of a business they want to buy and you will get one answer, and likely a much lower value.
  • Ask sellers what their business is worth and you will get a very different answer, and likely a much higher value.
  • However, if you ask accountants, attorneys, or other advisers, you will likely get completely different answers.

When there is a difference in perception of the value of a company between the buyer and the seller — or a difference in perception of the current value or of the future growth of the business — an earnout can be a pragmatic tool to bridge that price gap.

Earnouts are a useful way to bridge a price gap between the perceived value the seller and the buyer have for the business.


When to Use an Earnout

When do you use an earnout?

  • When selling your business, use an earnout if you are willing to bet on the future growth of your business and if you want to be involved in the business after the sale.
  • If you believe your business has a lot of unrealized potential, an earnout may be suitable for you.
  • This tool is also commonly used in larger business sales in the middle market where the buyer wants to incentivize the seller to realize goals in the future.

Benefits of an Earnout

For buyers, structuring the sale as an earnout offers the following benefits:

  • Protects the buyer against overpaying for a company that does not meet its future goals
  • Forces the seller to keep some skin in the game
  • Provides some financial incentives for the seller to be involved with the business after the closing

For sellers, structuring the sale as an earnout offers the following benefits:

  • Potentially increases the amount the business will sell for
  • Provides the opportunity to sell the business for a higher price than what the buyer would be comfortable paying outright

Should I Consider an Earnout?

When deciding to structure a sale as an earnout, use caution. Earnouts are prone to litigation. There is a lot of risk in any transaction that involves future conditions, especially when the seller is expected to essentially work for a new boss.

The seller should realize that they are no longer in control of the business after the closing and during the earnout period. The seller, who was once the owner and sole decision-maker of their business the day before closing, must now understand that the conditions of the earnout must be met on the buyer’s terms because the business is now owned by the buyer.


Calculating the Amount of the Earnout

First, determine how much of the purchase price you are willing to risk on the earnout portion of the transaction. Most earnouts are tied to the future performance of the business over a one- to three-year period.

  • For high-tech and service-based companies, the earnout may be as high as 60% to 80% of the transaction price.
  • For most companies, the earnout represents 10% to 25% of the value of the business.

The amount of the earnout primarily depends on the risk involved.

For example, if there is a customer concentration issue and most of the revenue is generated by one or two customers, the earnout may be a very high percentage of the purchase price.


The Basis for the Earnout

A critical question to ask and consider is: What is the earnout based on? Is it based on revenue, earnings, or some other criteria? Here are five ways an earnout can be structured. All have pros and cons and the circumstances of the specific sale will determine what the earnout should be based on.

  • Revenue. This is preferred by sellers and is the easiest to calculate, although revenue can be easily manipulated.
  • Net income. This is preferred by buyers, although these numbers can also be manipulated.
  • Non-financial targets. These include the retention of customers.
    Earnings, typically EBITDA. This can be manipulated through inflating expenses.
  • Gross profit. This eliminates the possibility of the buyer inflating expenses.

Manipulating the Amount of the Earnout

As previously noted, a buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduction of the earnout. Earnouts are easily manipulated and should be used only if there is complete trust between the parties. If one of the parties wants to, they can easily manipulate the calculation of the earnout.

Take Google, for example. Google used earnouts extensively when purchasing companies and would base the earnouts on milestone-based compensation and other criteria. Now, however, they have stopped using earnouts because they found it was too difficult for them to calculate the earnouts because the data they were based on was so easily manipulated.

A buyer can inflate the expenses or apply corporate overhead from the parent company to the acquired company’s books, resulting in a reduced earnout.


Other Factors to Consider When Selling Your Business

Many sellers and buyers forget to take into account several other factors that can influence the earnout. Here are some factors, in the form of questions, that can affect an earnout and should be considered before one is entered into.

  • What if the buyer sells the business after the closing?
  • What if the buyer merges the business after the closing with another entity?
  • Will the seller have a right to inspect the buyer’s books after the closing?
  • Will the purchase agreement allow the seller to leave the business in the seller’s control, or largely unchanged after the closing?
  • Will the seller make sure that the business can be run independently after the closing?
  • Who will decide on the final calculations of the earnout?
  • How will the progress of the earnout be evaluated?
  • When will the progress calculations take place? At the end of a set time period? Is it monthly, quarterly, or annually? Is it allocated on a regular basis or in one lump sum?
  • Will the purchase agreement define all payments as non-refundable? This would prevent the buyer from later trying to reclaim some of these payments if the seller does not meet the predetermined goals.

When structuring an earnout, avoid all-or-nothing cliffs. Earnouts should not be all or nothing. Rather, they should be based on a graduated scale.

For example, if the seller must achieve $10 million per year in revenue, but that year they only achieved $9.9 million, then they should not forfeit the entire earnout payment. Instead, they should still receive a portion of the earnout.

Whenever there is a cliff in the calculation of the earnout, there tends to be a lot of disagreements and manipulation of the calculation if the calculation is close to the edge.

Finally, hire the best advisers you can because earnouts are frequently subject to litigation. Have the right professionals in place to help the earnout be a success.


When Earnouts Work Well

Earnouts work very well if your company has a track record of meeting budgets and projections. Earnouts are used commonly in the following scenarios:

  • Concentration of customers, clients, key employees, where the earnout would be contingent on retention of customers, clients, or key employees after the sale
  • Volatile industries, where there are major changes within an industry and the seller still wants to sell despite those changes
  • Supplier retention issues, or if the business is highly dependent on one supplier, and the earnout is then structured on the retention of that supplier
  • Distressed businesses

Earnouts tend to work very well when the buyer is going to run the business the same after the closing as the seller ran the business before the closing.

Certain types of companies that often use earnouts include the following: consulting companies, companies where the owner is responsible for much of the sales, companies where there is no formal management team, companies whose family members are heavily involved in the company, and professional practices.


Tax Implications

Earnouts are mostly treated as installment payments, which allows the taxes to be deferred. They are also used for tax strategies in mergers & acquisitions. We recommend that you consult with your CPA or tax advisor to consider the tax implication of the earnout before considering one.


Conclusion

An earnout is an indispensable tool to close more transactions. However, selling a business in this way has its share of risks, and buyers and sellers should take precautions when using an earnout. Hire the absolute best advisers you can and carefully draft the purchase agreement to accurately and completely address the earnout. Earnouts are very subject to litigation, so hire an experienced attorney. When used properly, earnouts are a powerful tool to bridge price gaps and sell businesses in a way that benefits all parties involved.

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