If you are considering selling your company, it is important to know an earnout is an option. An earnout can be the bridge between your asking price and what the buyer is willing to pay, allowing you both to accomplish your goals. Understanding how an earnout works allows you, as the seller, to consider all your options. 

This guide explains what an earnout is, when it is used, how it is structured, and common pitfalls. 

What Is an Earnout?

An earnout allows both buyer and seller to settle on a purchase price. In short, an earnout divides up the total purchase price into an immediate payment and a deferred payment. For example, if the seller believes his company to be worth $120 million and the buyer thinks its value is $90 million, an earnout can cover the difference. In this case, the buyer would pay $90 million upfront and structure an earnout for the remaining $30 million. 

An earnout is also contingent upon the performance of the newly purchased company. In other words, there are strings attached. This motivates the seller to increase company performance post acquisition, which reduces the risk on the buyer. Company performance is objectively measured by key metrics that both parties determine beforehand. For example, these metrics can look like meeting a certain revenue or EBITDA margin, or retaining key customers. 

Earnouts in M&A: When Are They Used?

There are many situations where using an earnout makes sense. For example, perhaps the seller has just acquired a big customer or launched a marketing campaign, and expects the business to exceed past performance. The seller believes the purchase price should reflect this advantage, while the buyer is skeptical. After all, from the buyer’s perspective, his or her concerns are valid: what if the big customer falls through, or the marketing initiative fails? 

With an earnout, the seller receives down-the-road payments when the business does, in fact, meet expected performance goals. If the business does not, then the buyer does not have to make the corresponding payment to the seller. Below are some specific situations where an earnout makes sense. 

Bridge a Valuation Gap

If the buyer and seller want to work together but do not see eye to eye on the purchase price, an earnout allows them to move past this hurdle. Another common way to bridge a valuation gap is using a seller note. However, a seller note is not contingent on company performance. While a seller note is nice because it gives the seller guaranteed later payouts, it does not allow the payments to increase based on company performance. Effectively, the payment cap is lower. This may be undesirable if the seller believes his or her company will perform highly in the near future. 

Improve Ownership Transition

Passing the baton is not without risk. To reduce risk of company harm during the ownership transition, the buyer may want to include an earnout. This works because a later earnout payment motivates the seller to set up the company for continued success. In other words, the seller is financially motivated to see the company continue to perform, rather than simply wanting to “get paid and get out.” When the buyer and seller’s interests are aligned in this way, the company has more support to succeed. 

Sell to the Right Buyer

Sellers often want to hand the business off to someone who will continue the business legacy. If the seller finds a buyer with a shared vision for the company, but the parties do not agree on purchase price, this can be disappointing. An earnout allows the seller to “have their cake and eat it too”— not having to sacrifice either purchase price or the ideal buyer. 

If you are struggling to find a buyer who sees eye to eye on your business legacy and also has the capital to help you reach your goals, check out 1719 Partners. Our legacy is supporting your legacy. 

Sell at the Right Time

There are many reasons why it may be the right time for the owner to sell. Maybe he or she is facing health obstacles or burnout, or it is time for retirement. Without an earnout, the seller would have to decide between selling immediately, and receiving a lower purchase price, or waiting a few years until the purchase price can reflect company growth. In fast-growing or newer companies, this issue is extra relevant. An earnout allows the seller to sell at the right time without sacrificing on future business gains. 

Earnout Structures

There are many ways to structure an earnout. Earnouts should have a defined term, typically lasting one to three years. In addition to the term, performance metrics are also clearly defined. This reduces confusion between the buyer and seller. For example, the chosen metrics may be related to revenue, EBITDA, or customer retention. 

Earnouts are also structured through percentages. For example, an earnout might be a percentage of revenue, revenue associated with key customers, or profits or EBITDA. 

Earnout Calculation Examples

Exact earnout payouts are calculated based on the terms. In addition to the percentages mentioned above, earnouts have more detailed terms as well. These specific details limit the earnout’s maximum payments. For example, an earnout might have a lifetime cap of $1 million. This means throughout the earnout’s entire term the payments cannot exceed $1 million. Another structure might be 10% of revenue annually if the agreed-upon metrics are met that year, as well as a yearly maximum payout of $500,000, and a lifetime maximum of $1.5 million. This earnout may also end in four years. In addition, if metrics are not met one year, that year’s payment could be $0. 

Common Pitfalls

As with any legal agreement, there are potential problems. In general, pitfalls are caused by nonspecific terms. Vague terms can look like an open-ended time horizon, no annual or lifetime payment caps, and more. 

Typically, earnouts include a dispute resolution section. This provides instructions for handling disagreements, such as deferring to a third-party accountant or auditor.

Considering an Earnout? 

Are you wondering if an earnout makes sense for you and your company? 1719 Partners has helped structure many successful transactions. We have seen earnouts play a crucial role in meeting both the buyer and seller’s goals. We understand that selling a business is a very personal process and situations can vary widely. 

If you are considering a sale or have general questions about earnouts, don’t hesitate to reach out.