An earnout is a financial term you’ll come across when a company is bought by another company. Imagine someone wants to buy your company. They offer you a certain amount of money upfront, but they also agree to give you more money in the future. This extra money (known as an earnout provision) depends on how well the company does after they buy it. This is called an earnout.
How Does an Earnout Work?
When you’re involved in selling your business, an earnout is a key part you can negotiate.
- Initial Price: First, you and the buyer agree on an initial price (purchase consideration) for your business. But there’s a twist: part of the total price is set aside to be paid later, based on how well your business performs after the sale.
- Performance Targets: You and the buyer set specific targets your business needs to hit in the future. The earnout structure can be about revenue, gross profits, or other financial KPIs important to the business’s success.
- Receive Payment: After the sale, if your business meets or exceeds these targets, you receive the earn out payment. Earnout provisions are spread out over a few years. If your business doesn’t meet the targets, you could get less money or none of the earnout at all.
- Earnout Milestones: The earnout period can be a few months to several years, depending on what you and the buyer decide upon, based on the earnout agreement. The earnout target motivates you to help the business succeed even after you sell it. Additional compensation also gives the buyer some protection against overpaying if the business doesn’t perform as expected.
An earnout dispute happens when you and the buyer of your business disagree on the terms of the earnout provision after the sale has been completed. This kind of disagreement usually pops up if there’s confusion or differing opinions about how the earnout targets have been met or how the additional payments should be calculated.
If the business does well and those targets are met, you expect to receive the fair value of the payments. However, the buyer could see things differently. They could argue that the targets were not met or interpret the financial results in another way, leading to a lower payment than you expected.
This situation can become complicated if both sides have different interpretations of how the earnout performance metrics should be measured. For example, you will think that all sales should count towards the target, while the buyer can exclude certain sales for various reasons.
An earnout dispute can be tough to resolve because they involve financial data management and interpretations of the contract terms.
To prevent or address these disputes, it’s crucial to have clear, detailed terms in the earnout agreement that specify how targets are measured, what counts towards those targets, and how disagreements will be resolved.
Sometimes, bringing in a neutral third party, like an arbitrator or mediator, can help solve the dispute without going to court.
The earnout formula is a specific financial metric to calculate how much extra money you’ll get after selling your business, based on how well the business does in the future. This formula is part of the earnout provision in your sale agreement.
Here’s a simplified example to help you understand how it works:
- Set Performance Targets: First, you and the buyer decide on specific targets the business needs to achieve. These could be revenue targets, net profit margins, customer acquisition numbers, or other important metrics.
- Define the Earnout Period: You agree on a time frame, often a few years, during which the business’s performance is measured against these targets.
- Choose the Calculation Method: The formula will detail how to calculate the earnout payment. For example, it could say you get a certain percentage of revenue over a specific target, or a lump sum payment if profitability reaches a certain level.
Here’s a basic formula example:
- Revenue Based Earnout: If the business achieves $1 million in cash in the first year after the sale, you get an additional $100,000. For every $100,000 in revenue above $1 million, you get an extra $10,000 in cash flow.
- Profit Based Earnout: If the business’s profit margin exceeds 20% in the first two years, you receive $50,000 for each percentage point above 20%.
The exact formula varies based on what you and the buyer agree upon. It is fair to both parties, rewarding you for the business’s success after the sale while giving the buyer confidence that they’re paying an appropriate amount based on financial performance.
Benefits of an Earnout
An earnout can offer you several benefits when you’re selling your business. Let’s explore these advantages:
- Higher Sale Price: An earnout can help you get a higher total sale price for your business. Since part of the earnout payment depends on the future performance of the business, it allows you to argue that the buyer should pay more if the business does well. This means you could end up receiving more money than the initial sale price.
- Eases Negotiations: Negotiating the sale of your business can be tough, especially if there’s an enormous gap between what you think your business is worth and what the buyer wants to pay. An earnout can bridge this gap. It reassures the buyer that they’re not overpaying, as future payments are tied to the business’s success, making it easier to agree on a deal.
- Rewards for Future Growth: If you’re confident in your business’s potential for future growth, an earnout ensures you’re rewarded for that growth. Since you’ll receive payments based on the business hitting certain targets after the sale, you benefit financially if the business continues to perform well.
- Smooth Transition: Earnouts often involve you staying with the business for a while to ensure it hits its targets. This can lead to a smoother transition for the business, its employees, and its customers, as you’re there to help maintain stability and continuity.
- Alignment of Interests: Earnouts align your interests with those of the buyer. You both have a stake in seeing the business succeed after the sale. This can lead to better cooperation and support from the buyer, as they’ll want to ensure the business meets its targets so they get their money’s worth.
- Flexibility: An earnout clause offers flexibility in structuring the deal. You can negotiate different payment terms, such as the duration of the earnout period, the performance metrics to be used, and how payments will be made. This allows for a customized agreement that suits both your needs and those of the buyer.
Downsides of an Earnout
While earnouts can seem like a great way to bridge the gap between what you want for your business and what the buyer will pay, they come with their own set of challenges.
Let’s look at the downsides:
- Complexity: Earnouts can make the sale of your business much more complicated. Agree on future performance metrics, how they’ll be measured, and what happens if those targets are met or missed. This complexity can lead to misunderstandings and disputes down the line.
- Potential for Disputes: Because earnouts are based on future performance, there’s a lot of room for disagreement about whether targets have been met. You could think you’ve hit the goals for an additional payment, but the buyer could interpret the results differently. These disputes can be stressful and can even require legal action to resolve.
- Loss of Control: If you’re staying on to help the business meet its earnout targets, you can find yourself with less control than you’re used to. The new owners have the final say, and their decisions could affect the business’s ability to meet the agreed-upon targets, affecting your earnout payment.
- Focus on Short-term Goals: Earnouts can sometimes encourage a focus on short-term performance at the expense of the long-term health of the business. You can push for strategies that boost immediate results to meet earnout targets, even if those strategies aren’t the best for the business in the long run.
- Delayed Payment: Part of your compensation from the sale is delayed until the earnout targets are met. A delayed payment means you won’t receive all the money up front, and there’s always a risk that you could not receive the full earnout amount if the business doesn’t perform as expected.
- Stress and Uncertainty: The period during which earnout targets must be met can be stressful. You’re watching the business’s performance closely, knowing that your financial compensation depends on meeting certain goals. This uncertainty can be difficult to manage, especially if the business faces unexpected challenges.
- Integration Challenges: If you’re working with the new owners to meet earnout targets, there could be challenges in integrating your approaches and strategies. Differences in vision, management style, and company culture can create friction, making it harder to achieve the targets.