Earnouts are typically used in business acquisitions when the buyer and seller cannot come to terms on an upfront cash price. Instead, the seller agrees to accept additional payments after the sale closes as a way to bridge differences over the company’s valuation.
For example, both parties agree on a purchase price of $50 million, where the seller receives an initial cash payment of $40 million at closing. The buyer agrees to pay the remaining $10 million in installments, based on the company’s earnings or other performance metrics, over a specific period.
Earnouts can benefit both parties
Advantages exist for buyers and sellers to consider an earnout when disputes arise over valuing a company. Buyers can typically spread out payments over one to three years or even longer, and those payments may be lower if the earnings or performance do not meet projections.
On the other hand, sellers can maximize the potential sale price while minimizing near term taxes by spreading the revenue over several years.
Potential disadvantages also should be considered
Earnouts can also have drawbacks for both parties. Buyers may have to put up with the seller’s continued involvement in the business to monitor revenue growth. This can inhibit the buyer’s ability to run the company as they see fit. Sellers who exit the business sooner or do not negotiate for ongoing authority risk losing control of the ability to navigate toward achieving the maximum earnout. A significant risk for sellers is that they stand to make less money from the sale if future earnings drop.
Key considerations in crafting earnouts
Earnouts often cause post-closing disputes between buyers and sellers. They are complex agreements involving several considerations, including:
- Financial metrics: Buyers usually prefer a structure where EBITDA (earnings before interest, taxes, depreciation and amortization) milestones are met. Sellers may prefer to have milestones based on the business’ gross revenues or other more straightforward targets.
- Time period: Prior to the COVID pandemic earnouts were typically one to three years. Recently, buyers have sought longer earnouts.
- Accounting standard: Which accounting practices will be used to determine whether the financial metrics are achieved? The seller’s metrics prior to closing? The buyer’s? GAAP? Both sides must also consider how to deal with other economic dynamics such as the effect of expenses added by buyer after closing.
- Absolute or graduated targets: Will there be an all-or-nothing milestone (i.e., a single target to be reached at the end of the earnout period)? Or will there be graduated earnout payments based on incremental targets?
Earnouts are complicated, containing no hard and fast rules, which means it is advisable to seek legal counsel from attorneys who focus on business acquisitions, especially sales ranging from tens of millions to hundreds of millions of dollars.