When selling a business, it’s common for buyers and sellers to face challenges in agreeing on a fair valuation.
One solution to bridge this gap is an earnout.
In this article, we will explore what an earnout is, why it’s needed, when it would be used in selling a business, and the advantages and disadvantages of this approach.
What is an Earnout?
An earnout is a bonus seller finance payment linked to the future performance of the business being sold.
It is not guaranteed like seller financing, which is a contracted payment.
Instead, earnouts are contingent on the business achieving specific financial targets, such as revenue or cash flow growth.
Why is an Earnout Needed?
Earnouts are needed when there is a difference in valuation expectations between the buyer and the seller.
By linking part of the payment to future performance, both parties can reach an agreement that accommodates their respective valuations.
When is an Earnout Used in Selling a Business?
Earnouts are often used in situations where:
- The seller believes the business has significant growth potential that the buyer may not fully appreciate.
- The buyer wants to incentivize the seller to continue contributing to the business’s success after the sale.
- The business has good fundamentals but poor management, and the buyer believes they can improve performance.
Earnout Examples
Here are a few examples of common earnouts:
Revenue-Based Earnout: In this type of earnout, the seller receives additional payments based on the business achieving specific revenue milestones over a defined period. For example, the seller may receive a bonus payment if the company’s annual revenue exceeds a certain threshold.
EBITDA-Based Earnout: This earnout structure ties bonus payments to the company’s Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). The seller may receive a percentage of EBITDA above a predetermined threshold, ensuring that they benefit from the company’s profitability growth.
Customer Retention Earnout: In this scenario, the earnout is linked to the retention of existing customers or clients after the sale. The seller may receive additional payments if the business maintains a certain level of customer retention or achieves a specific growth rate in its customer base.
Product Launch Earnout: If the business being sold is in the process of developing a new product or service, an earnout can be structured around the successful launch and subsequent sales performance of that product. The seller may receive bonus payments based on the product’s sales or market penetration.
Hybrid Earnout: This type of earnout combines multiple performance metrics, such as revenue and profitability, to determine bonus payments. For example, half of the earnout could be based on achieving revenue targets, while the other half is tied to EBITDA growth. This approach allows both parties to share in various aspects of the business’s success.
Advantages of Earnouts
Here are a few of the advantages of earnouts:
- Bridge Valuation Gaps: Earnouts can help bridge valuation gaps between buyers and sellers, making it easier to reach an agreement.
- Incentivize Performance: By tying payments to future performance, earnouts can incentivize sellers to continue contributing to the business’s success after the sale.
- Risk Mitigation: Buyers can reduce their upfront investment and mitigate risk by paying for the business based on its actual performance.
Disadvantages of Earnouts
Earnouts can also have some drawbacks, including:
- Complexity: Earnouts can be challenging to structure and negotiate, requiring clear rules for triggering bonus payments and allowing sellers to audit financial records.
- Potential Disputes: Earnouts can lead to disputes between buyers and sellers if there are disagreements about the business’s performance or the calculation of bonus payments.
- Uncertainty for Sellers: Since earnouts are not guaranteed, sellers may face uncertainty regarding their total compensation from the sale.
Conclusion
Earnouts can be a valuable tool for bridging valuation gaps and incentivizing sellers to contribute to a business’s success after the sale.
However, they also come with potential challenges and risks.
Both buyers and sellers should carefully consider the advantages and disadvantages of earnouts when negotiating the sale of a business.
