I’ll Pay You Later – Considering an Earnout

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’s 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.

The Basics of Earnouts

Definition of an Earnout

An earnout is a useful tool in the M&A world 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 a specific metric, such as the business’s performance after the closing. An earnout essentially means the seller must earn part of the purchase price. Part of the purchase price is paid at closing, with the remainder paid after the closing based on the future performance of the business or some other metric that’s agreed on. 

How 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 lack the operational expertise and manpower 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.

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.

Why Earnouts Are Used

What is the value of a business? That depends on who you ask. The seller, who is emotionally invested in their business, often believes it should be valued higher than what the buyer thinks the business is currently worth. Lawyers, accountants and other advisors might tell you a third answer altogether. 

When there’s 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 the future growth of the business – an earnout can be a useful tool to bridge that price gap and finish a deal. 

When To Use an Earnout

For being such a common tool in many industries, many assume an earnout will be part of their deal structure. That is not always the case. Here are some examples of when an earnout is most beneficial:

• When selling your business, use an earnout if you’re 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 Using an Earnout

Earnouts are more than a financial tool to bridge price gaps. When using one, they have a series of advantages, both financial and non-financial, on both sides of the transaction. Let’s first take a look at the benefits of an earnout for the buyer:

• Offers the buyer protection against overpaying for a company that doesn’t meet its 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.

Next let’s examine the benefits for you, the seller, for including an earnout in your sale structure:

• Potentially increases the value of your business. 
• Provides the opportunity to sell your business for a higher price than what the buyer would be comfortable paying outright.

The Mechanics of Earnouts

Deciding To Use an Earnout

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

You should realize that you are no longer in control of the business after the closing and during the earnout period. You, who were once the owner and sole decision-maker of your 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

First, determine how much of the purchase price you’re 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 higher percentage of the purchase price.

Deciding on the Basis for the Earnout

A critical question to ask and consider is this: 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. Each has pros and cons and the circumstances of the specific sale will determine what the earnout should be based on.

1. Revenue: Preferred by sellers and is the easiest to calculate, although revenue can be easily manipulated.
2. Net Income: Preferred by buyers, although these numbers can also be manipulated.
3. Non-Financial Targets: Includes the retention of customers.
4. Earnings, Typically EBITDA: Can be manipulated through inflating expenses.
5. Gross Profit: Eliminates the possibility of the buyer inflating expenses.

Earnouts are easily manipulated and should only be used if there is complete trust between the parties.

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 only be used 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 to use 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 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 Negotiating an Earnout

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

• What if the buyer sells the business after the closing?
• What if the buyer merges the business after the closing with another entity?
• Will you have a right to inspect the buyer’s books after the closing?
• Will the purchase agreement allow you to leave the business in your control or largely unchanged 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 you must achieve $10 million per year in revenue, but you only achieved $9.9 million, then you shouldn’t forfeit the entire earnout payment. Instead, you 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 disagreement and manipulation of the calculation, especially 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 quite well when your company has a track record of meeting budgets and projections. Earnouts are used commonly in the following scenarios:

• If there is a concentration of customers, clients, key employees, where the earnout would be contingent on retention of customers, clients, or key employees after the sale.
• For volatile industries, where there are major changes within an industry and you still want to sell despite those changes.
• With supplier retention issues, or if the business is highly dependent on one supplier, and the earnout is structured on the retention of that supplier.
• For distressed businesses.

Earnouts tend to work best when the buyer is going to run the business the same after the closing as you 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 of Earnouts

Earnouts are mostly treated as installment payments, which allows the taxes to be deferred. They are also used for tax strategies in mergers and acquisitions. Consult with your CPA or tax advisor to consider the tax implications of the earnout before considering one.

Key Points

• An earnout is an indispensable tool to close more transactions, but selling a business in this way has its share of risks – 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 often 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.
• If you’re still considering an earnout after reading this, visit our Morgan & Westfield page for a thorough article on earnouts. It includes sample wording and even more in-depth information and tips regarding how to structure an earnout. www.morganandwestfield.com/knowledge/earnouts/