Earnouts are one way to help a business for sale transaction cross the finish line. This method is most commonly used when a buyer and seller are having difficulty settling on a sale price because they don’t see eye on eye on the growth, performance, and value of the business. A well-structured earnout can help overcome this discrepancy. The buyer agrees to pay the original seller additional compensation in the future if specific pre-determined criteria and performance targets are met. There is a possibility that the seller will lose out on the additional compensation if the business does not perform as expected.
Earnouts can be a useful tool in a few different circumstances, including when
- A business is listed for sale following a period of exceptional profits or growth and this success has not had the opportunity to be replicated.
- A business has one or two customers that make up a significant percentage of sales.
- A business has recently entered into a new market or introduced new products and services.
How it works
There is no one specific formula to be followed for earnouts. Each deal is as unique in its structure and terms as is the business that is being sold. Depending on the circumstances, an earnout can take place over twelve months or be extended over a three to five year period. The buyer typically pays a portion of the asking price up front and then settles the balance through future payments.
Successful earnouts are carefully structured with an emphasis on objective measures such as performance metrics, typically financial targets, to determine the future compensation that will be paid to the seller.
Both parties benefit
When negotiated correctly, both the buyer and the seller benefit from the earnout model. Primarily, this structure can help eliminate some of the uncertainties faced by buyers and allow the seller to enjoy the benefits of future growth made possible by the work they did before selling the business.
A second important benefit to earnouts is that it gives a buyer a significant amount of confidence and reassurance about the future of the business. When a seller believes in the business so strongly they are willing to defer payments into the future, this can help assuage fears and close the deal.
Earnouts can help to reduce the immediate financial burden on buyers. Access to liquid funds and adequate financial resources is one of the main barriers for buyers and earnouts alleviate much of this strain.
Finally, earnouts are an effective way to motivate all the involved parties to work together to reach the same goals. This cooperation can benefit company performance before, during, and after the sale is completed. It can help with things like employee and customer retention and also ensure a smooth and successful transition between owners.
Tips to minimize risk
Using the earnout method involves a level of risk but risk is inherent to some degree in all business for sale transactions. There are a few key strategies that should be used to make the earnout as successful as possible for both the buyer and the seller.
Using a business broker and team of experts that are familiar with structuring earnouts and seeing them through to completion is critical. People experienced with earnouts can troubleshoot issues before they arise, problem-solve effectively, and maximize the probability that the deal reaches fruition.
There should be no verbal agreements when structuring earnouts. An easy to understand contract with clear and objective terms is the cornerstone of a successful earnout. It bears mentioning that the contract should outline all the accounting assumptions that will be used when determining future payouts to avoid confusion or misreporting of earnings and profits. While this type of document can take a significant amount of time and effort to put together, without it the deal is far more likely to sour and leave one or both parties missing out on the benefits of an earnout.
Last but not least, the earnout agreement should include a dispute resolution process to be followed if issues arise before the final payment is made. Having a process in place before it is needed can help to save a significant amount of time and money. It can get the deal back on track more quickly should problems arise. The dispute resolution process gives both parties objective steps to be followed to promptly and successfully mediate circumstances that could threaten the success of the plan.
Earnouts can be very successful for both buyers and sellers when structured properly. While many may shy away from this transaction method for fear of the risks involved, having a better understanding of the benefits and putting an individualized plan in place can help to overcome these fears and close a deal that might otherwise be lost. If you have questions about using an earnout to buy or sell a business, please give us a call! We can chat more about how it works and help you determine if it is the right choice for your business goals and circumstances.