Garren Work, MBA

VP, Mergers & Acquisitions Advisor for Businesses <$100MM

Click here to view original article

An Earnout is a contractual provision allowing the Seller of a business to obtain additional compensation in the future, contingent on the business achieving predetermined goals or targets.

Typically, Earnouts are based on financial goals or targets such as achieving a specific Revenue or Gross Profit (e.g. The Seller receives an additional $1M upon achieving $20M Revenue over the next 12 months post-closing). Less common, Earnouts can be tied to specific performance, such as employee retention, contract renewals, or any other actions agreed upon by both parties.

Earnouts can be further categorized by:

Payment mechanism

• All or nothing.
• Tiered with partial consideration - $500k paid at $18M Revenue, $1M at $20M Revenue, or $1.5M paid at $22M Revenue.
• Percentage or sliding scale – Payment equal to 5% of Revenue.

Target Type

• Over and Above - Targets growth exceeding current business performance.
• Status Quo - Sets targets similar to recent business performance.

Payment timing – Typically 1 year, but Earnouts can extend over several years

Limits

• Capped – With a designated limit.
• Uncapped – No upper limit.

Earnouts bridge valuation gaps. If a Buyer and Seller agree on a Purchase Price and a Buyer has full financing or all cash, then Earnout is typically avoided altogether. However, Earnouts become handy when Buyer and Seller are not aligned on Purchase Price and/or the Buyer does not have access for full financing.

If the business is showing good and continued growth, has a significant project on the horizon, or the Buyer and Seller want to share in synergies from collaboration without maintaining equity ownership, “over and above” Earnouts can be an answer to overcome valuation gaps.

“Status quo” Earnouts are a bit harder for Sellers to understand. Market multiples factor in an ordinary risk appropriate for the size, industry, and other factors, so usually an Earnout shouldn’t apply. However, extraordinary risk factors unique to the Business can impact perceived value and/or lending options, creating a gap that an Earnout can bridge.

Examples of extraordinary risk include:

Inconsistent Historic Financials – Typically Buyers want to see 3-5 years of financials showing steady, modest growth. Inconsistency, such as drops in year-over-year performance, sporadic trends, or even rapid growth, may add perceived risk to a deal, even if properly supported explanations are provided.

Seller Retention – Earnouts help ensure a Seller stays motivated and performs consistently during the transition to new ownership performance. This need increases with:

• Multiple exiting owner-operators.
• Involvement of family members.
• High-touch relationships – Are customer relationships with the owner personally or the business?
• Experience disparity – Does the Seller have critical knowledge or relationships the Buyer lacks? This can vary from Buyer to Buyer.

Financing not available – If traditional financing is unavailable, Seller Financing, including Earnouts, may be the next best option. Common reasons Financing is not available:

• High-risk industries that carry additional liabilities. 
• Messy historical financials – Banks typically lend on historic tax returns.
• Growth and timing – Since banks lend on historic tax returns, if the business grew significantly since the last filed tax return, lending may be limited to the most recent tax return.

Specific Risk – Various factors can warrant an Earnout, including:

• High valuation expectations; Top dollar doesn’t always come in cash.
• Buyer-specific needs.
• Concentration concerns.
• Expiring/renewing contracts or leases.
• Industry-specific risk, such as regulation changes 
• Economic risk, such as recession cycles.

In deals where the parties are close but not quite in agreement, a well-structured, well-explained Earnout can help bridge the gap and finalize a deal getting it through the finish line.