What is an earnout and how to structure one that works
June 14, 2023 ⋅ 22 min read
As a business owner, you may have heard of the term “earnout” but aren’t quite sure what it means. An earnout is a performance-based bonus paid out over time, typically after the sale of a business. In this guide, we break down what an earnout is and how to structure one that works for you.
What is an earnout?
An earnout is a type of payment that is contingent on the acquired company achieving certain performance milestones. Earnouts are very common with the sale of larger businesses and can be a great way to align former owners with new owners in smaller businesses.
This type of arrangement is often used when selling a business, as it gives the buyer some flexibility in terms of how much they are willing to pay. The earnout period can last for several years, and the payments are usually made in installments.
What happens during an earnout?
During this time, the buyer will closely monitor the acquired company's performance, using specific metrics to determine whether or not the earnout payments should be made. If the company fails to meet the agreed-upon milestones, the buyer may forfeit some or all of the earnout payments.
Conversely, if the company outperforms expectations, the buyer may be required to make additional payments. Earnouts can be complex arrangements, but they provide a way for buyers and sellers to align their interests and ensure that the acquired company remains successful in the long term.
Earnouts may arise when there’s a disagreement in a company’s valuation. The seller wants to get the best price for their company, while the buyer may be wary about the profitability or growth of the company. Earnouts bridge valuation gaps between the buyer and seller, incentivize the seller to cooperate for a smooth transition and align the interests of both parties.
Why are earnouts used in merger & acquisition (M&A) deals?
Earnouts can benefit both business owners and buyers in an M&A deal (an M&A deal is used here to describe a business owner selling their company) by ensuring the companies will successfully integrate together. Earnouts are a type of contingent payment - they are designed to bridge the gap between the valuation of a company and the amount that a buyer is willing to pay.
There are several reasons why earnouts are used in M&A deals.
To bridge the valuation gap
When a buyer and seller are unable to agree on a price for a company, an earnout can be used to bridge the gap. The earnout allows the buyer to pay a lower price upfront, while the seller has the opportunity to earn additional compensation if the company performs well after the acquisition.
To reduce risk
Earnouts can also be used to reduce risk for both the buyer and seller. For the buyer, an earnout reduces the risk of overpaying for a company that does not perform as expected. For the seller, an earnout reduces the risk of selling their company for a lower price than it is worth.
To motivate the seller
Earnouts can also be used to motivate the seller to stay with the company after the acquisition. If the seller is eligible to receive additional compensation based on the company's performance, they are more likely to stay with the company and help it succeed.
Earnouts can be a valuable tool for both buyers and sellers. When used correctly, they can help to bridge the valuation gap, reduce risk, and motivate the seller to stay with the company after the acquisition.
Types of earnouts
Earnouts are a common feature when selling a business. They can be a valuable tool for both buyers and sellers, but it's important to understand how they work and how to structure them properly.
There are three main types of earnouts: performance-based earnouts, milestone-based earnouts, and profit-based earnouts.
Performance-based earnouts allow the seller to earn additional compensation if certain pre-agreed-upon performance metrics are met after the close of a deal. Common examples of performance metrics are revenue, growth, profitability, or customer retention.
By structuring a portion of the purchase price as an earnout, the parties can align their interests in achieving mutual goals and ensure a smoother transition of ownership.
While earnouts can be complex to negotiate and administer, they can also offer a valuable tool for both buyers and sellers to bridge gaps in valuation and reduce risk in a transaction.
In these arrangements, a portion of the purchase price is held back and paid out based on achieving certain targets or milestones, or when a specific event occurs (e.g., reaching a certain number of customers).
Similar to a performance-based earnout, this incentivizes the acquired company to continue performing well and provides a measure of protection for the purchasing company against unforeseen issues.
You’ll typically have to negotiate and agree to the specific milestones and timelines before the deal is completed.
Essentially, a profit-based earnout is an agreement that both parties will share profits until a certain sum is reached post-acquisition.
The seller will receive a portion of the profits generated by the business during a specified time period. This can be a win-win for both parties, as the buyer has an added incentive to continue growing the business, and the seller is able to maximize the value of their sale.
However, there can be challenges in determining the appropriate metrics to use in calculating the profit-based earnout, and it's important for both parties to have clear expectations and communication throughout the process.
Earnouts can help both the buyer and seller
Earnouts can be a valuable tool for both buyers and sellers. For buyers, earnouts can help to reduce the risk of overpaying for a target company. If the target company doesn't meet the earnout goals, the buyer doesn't have to pay the seller the additional money.
For sellers, earnouts can be a way to get a higher price for their company. If the seller is confident that they can meet the earnout goals, they may be willing to accept a lower purchase price upfront.
Earnouts can be a complex and time-consuming process to structure and negotiate. It's important to work with an experienced M&A attorney to ensure that the earnout is fair and protects the interests of both parties.
When structured properly and managed carefully, earnouts can be a valuable tool for both buyers and sellers. They can help to secure profitability for years to come and create a win-win situation for everyone involved.
Advantages of earnouts
A smart business owner knows that a successful deal isn't just about closing it, but ensuring both parties benefit in the long run.
Advantages of earnouts include:
Create a win-win scenario
Earnouts are a valuable tool that benefits both buyers and sellers during business deals, allowing a buyer to pay for future success, rather than solely basing the purchase price on the business's current value. This not only helps a buyer mitigate risk but also incentivizes the seller to continue growing the business post-sale.
Earnouts are an excellent way to allocate risk and reward between buyer and seller when risks and rewards are difficult to measure. This approach lets the buyer pay a higher potential reward to the seller while reducing their risk. If earnings before interest, taxes, depreciation, and amortization (EBITDA) exceed expectations outlined in the earnout, the buyer pays a higher purchase price; if EBITDA falls short, the buyer pays a lower purchase price.
Closes valuation gap
Earnouts can be used to bridge valuation gaps and expand the scope of potential transactions. With earnouts, buyers and sellers can disagree on a business's valuation but still agree to a deal.
Additionally, earnouts can improve negotiations, as buyers and sellers can jointly identify key growth drivers and develop a plan for future success.
Earnouts help manage uncertainty around future events. If the buyer and seller cannot agree on the certainty of future events that could affect business value, they can use earnouts where a portion of the purchase price depends on the occurrence or non-occurrence of a future event.
Aligns both parties
Earnouts create alignment between buyer and seller, particularly when the seller remains in the business after the deal is done. By using consulting agreements to maximize the purchase price, earnouts incentivize the seller to help the buyer during and after the transition, making the acquisition more likely to succeed.
While they may not be appropriate for every deal, earnouts are a valuable tool for smart business owners looking to maximize their returns.
Disadvantages of earnouts
While an earnout can be seductive due to its ability to bridge price gaps and create alignment, it is loaded with potential problems that are often difficult to solve.
With an earnout, the seller won’t get the money upfront, which can be a challenge for owners with short-term cash needs. Overly optimistic sellers may fail to achieve the defined performance targets due to a lack of resources or since they are no longer part of the acquired business.
Additionally, buyers can be discouraged from expending resources on objectives that do not give an immediate return, making the buyer less likely to invest in sales and operations initiatives that would benefit both parties. Disputes regarding performance targets may lead to legal complexities, which makes negotiations for an earnout a long and costly process for both parties involved.
Other disadvantages include:
Adverse incentives can be associated with disagreements between buyer and seller decisions since the two parties may have different priorities. The buyer seeks to minimize the earnout, while the seller wishes to maximize it. However, the buyer seeks to increase long-term growth at the cost of the short-term, which may make the seller uncomfortable if they remain in control of the business.
Earnouts can be manipulated by both parties. Buyers can reduce the amount owed by overspending on various expenses or by focusing only on short-term gains. At the same time, sellers can neglect long-term goals or make unrealistic growth projections.
Disputes are common
Disagreements often arise after earnouts agreements, resulting in costly and time-consuming arbitration or litigation. Careful consideration and drafting of the dispute mechanism in the earnout or purchase agreement are crucial to avoid uncomfortable situations.
Earnouts can be subject to interpretation, leading to disputes between buyers and sellers over how to calculate various aspects such as EBITDA, appropriate salaries, and debt.
Earnouts must be carefully drafted to anticipate and address potential problems. This complexity can make them challenging to manage and monitor, especially for retired sellers who no longer own the business.
Poor buyer performance
If the buyer's management team operates the business post-closing, there is a risk they may perform poorly, leading to further disputes with the seller. This decline in business performance may trigger questions regarding the buyer's management team's abilities. An earnout may also prioritize profits above long-term objectives, resulting in adverse incentives.
What is an earnout strategy?
The right earnout strategy can help you determine the appropriate amount of earnout to agree to.
When is it best to structure an earnout?
The best time to structure an earnout is when the company being acquired is expected to have significant growth in the near future. By tying the amount of the earnout to the company's performance, the buyer can incentivize the seller to continue to grow the business.
This can be an especially advantageous arrangement for experienced buyers who are looking to acquire a company with high potential but relatively low current revenue. By locking in a low purchase price and linking it to future growth, buyers can minimize their downside risk while still having the opportunity to participate in the upside potential of the business.
When an earnout structure should be avoided
While earnouts can be an attractive way to structure a deal, they are not always the best option. Here are three situations when you may want to avoid using an earnout:
When the buyer's ability to pay is uncertain. If the buyer is not confident in their ability to meet the earnout targets, it may be better to negotiate a different type of deal.
When there is potential for bad blood. If the parties are not on good terms, an earnout can create tension, and conflict, and means that you’ll have to spend more amount of time nurturing a sour relationship.
When the business is not doing well. If the business is struggling, an earnout may put too much pressure on the existing management team, and employees.
Key elements of structuring an earnout
The primary element of an earnout is the formula on which it is based, which should be objective and defined to minimize manipulation. Financial metrics for an earnout can include revenue, gross profit, net profit, or some variation thereof. Sellers usually prefer revenue-based earnouts while buyers usually prefer profit-based ones. Non-financial milestones or targets can also be used to measure an earnout's success and should be as specific and objective as possible. Most buyouts are paid proportionally as a simple percentage of a financial metric, rather than on an all-or-nothing basis. Payment triggers are typically annual and coincide with the company's financial reporting period.
Negotiating an earnout is a great way to ensure a successful and profitable sale for both the buyer and the seller. When structuring an earnout, make sure you’re setting the right objectives, including:
Milestones that need to be achieved
Performance measures that must be met
The length of the pay period
Amount of capital involved
Any restrictions or actions potentially impacting earnings or the business’s value
When approaching any business transaction, thorough consideration of the above items can make all the difference when it comes to aligning on fair terms and a positive outcome for both parties. First, the duration of the earnout should be carefully considered — an earnout that’s too long will risk the seller losing focus, and a deal that's too short won’t give the seller enough time to achieve the goal. The objectives identified in the agreement should also be realistic but challenging - they should link to measurable goals and represent an achievable challenge for all parties involved.
Additionally, allowance should be made for any external factors affecting performance as part of the agreement such as changes in market conditions or competitive dynamics. If done correctly, setting up an earnout can provide both parties with achievable mutually beneficial outcomes.
Financial metrics vs. non-financial metrics
There are two types of performance metrics to consider when structuring an earnout — financial and operational. Financial metrics are revenue-based and profit-based, focused on the total amount of money flowing into the business over a specific period of time.
Financial metrics allow business owners and buyers to determine the value of a potential acquisition, as well as create a more effective earnout formula that rewards performance and growth.
Operational metrics include milestones and targets, such as customer retention. These metrics may also be included in many earnout agreements and can help ensure that both parties have skin in the game long after the sale has been completed. It's important that these milestones and targets be objective so there can be no dispute when determining whether or not they have been met. Additionally, specificity is key when setting milestones and targets; clearly defining what constitutes success will make it easier for both parties to determine if payments should be made upon completion of those milestones/targets.
When negotiating an earnout formula, it’s important to carefully consider all components—financial metrics as well as non-financial milestones/targets—in order to ensure that all parties involved understand exactly how payments will be triggered and what constitutes success. By taking into account various aspects such as proportions, objectives, and specificity you can craft an earnout formula that works best for everyone involved in the transaction.
How do you calculate an earnout?
The first step in structuring an effective earnout is calculating the total purchase price, which signals to the seller how much money will be exchanged if all conditions are met and it provides a way for them to assess their potential return on investment (ROI). It signals to the seller how much the buyer is willing to pay.
Next, buyers need to determine their up-front payments - these should be equal to what they calculate as their enterprise value and represent capital at risk if the target underperforms during the earnout period.
You also need to choose payments that will depend on the future performance of the business, known as contingent payments. These payments can be fixed amounts or a percentage of how much money the company earns after you buy it. For example, if you pay $1 million upfront and 10% of post-closing revenue, then if the company earns $10 million or more during an agreed-upon period, you'll have to pay another $1 million.
After you decide on the price, you’ll determine the length of time for the earnout period. This should be long enough so that each party can reach their goals, typically around one to three years. The length will depend on the type and size of the company being bought. Both sides should agree on how to measure success and when to pay out the money. It's best if there's just one payment at the end instead of yearly payments, which could cause problems between the buyer and seller.
When structuring an earnout, buyers, and sellers need to really collaborate together to keep risks low and maximize benefits.
Tips for negotiating a successful earnout
Understanding what an earnout entails can dramatically increase the success of your negotiations and help you bring in additional returns on investment down the line. Here are four key tips to ensure you successfully negotiate an earnout as part of your sale.
Researching the current market value of a company is crucial when considering an earnout deal. After all, understanding the potential risks and rewards can mean the difference between success and failure.
With careful analysis, investors can come to a better understanding of the true value of the company, which can help them negotiate a deal that is fair to both parties. While there are certainly risks involved in such deals, the potential rewards can be substantial, making it an option that is well worth considering.
Getting a third-party valuation from Baton can help you identify how much your business is truly worth.
2. Understand value drivers
Understanding the factors that drive value in a business is crucial to negotiating more favorable terms for yourself. It requires knowledge of the industry, competitive landscape, and financial performance, among other things.
By gaining a deep understanding of these factors, you can identify areas where you can add significant value and demonstrate your worth to potential employers or partners.
Armed with this knowledge, you can approach negotiations with greater confidence and make well-informed decisions that will benefit you in the long run.
3. Establish milestones
When entering into any business relationship, it's important to establish clear expectations and goals in order to ensure both parties are fulfilling their responsibilities.
One key way to do this is to set milestones that hold each party accountable for achieving specific targets within a given timeframe. By establishing these milestones, you create a roadmap for success and have a clear way to measure progress.
This not only ensures that everyone is doing their part, but it also helps to build trust and transparency within the relationship.
4. Make sure your plan is enforceable
An earnout agreement can be a complex and critical part of a business deal. It can ensure that the seller receives the full value of their business or leave the door open for disputes and legal battles.
That's why it's important to have your earnout agreement reviewed by an attorney or financial advisor. Not only can they help ensure that the terms are fair and reasonable, but they can also help make sure that the agreement is legally binding and enforceable.
By investing in professional advice, you can give yourself peace of mind and avoid potential conflicts down the road.
Possible Legal, Accounting & Tax Implications
While earnouts can provide significant benefits to buyers and sellers, there are also a number of potential legal, accounting, and tax implications that should be considered prior to entering into an earnout agreement. If you are contemplating an earnout as part of your business sale, it's important to be aware of these implications, as they can vary depending on the payout structure of the deal.
From a legal perspective, it is important to ensure that the earnout provisions are clearly defined and enforceable.
While earnouts can provide a unique opportunity to increase overall deal value, they can also present a significant risk for both parties involved. Depending on the specifics of the agreement, an earnout can require significant attention related to proper structure and execution so as to avoid any disagreements later on. When executed correctly, an earnout can provide tremendous benefit in the form of additional compensation, but if not structured with caution it could result in costly litigation that detracts from its original purpose.
Baton always recommends working with a legal expert when structuring an earnout, we’re happy to support you with a referral if needed.
Accounting & tax considerations
From an accounting standpoint, it is important to consider how the earnout payments will be treated for financial reporting purposes. Earnouts can be complex transactions, but with careful planning, they can be an effective way to align the interests of buyers and sellers. There may be tax implications associated with the receipt of earnout payments, and it is important to consult with a qualified tax advisor to determine the most advantageous way to structure the transaction.
Before entering into such an agreement, both parties should have a clear understanding of the accounting and tax implications of the arrangement. Sellers need to be aware that any earnout payment will be subject to income tax, which means they must set aside money for that purpose when computing their personal financial planning. As far as accounting is concerned, both buying and selling sides must determine how to report any earnout payments and should adhere to relevant Generally Accepted Accounting Principles (GAAP). Additionally, since most earnouts are structured as contingent liabilities, buyers should consider the possibility of having to pay more than originally anticipated upon final reconciliation. All in all, careful attention must be paid when deciding on terms and conditions surrounding an earnout in order to avoid costly consequences in the future.
Again, we always recommend working with a tax professional and have dozens of partners that we can connect you to.
Real-world examples of an earnout
Throughout history, there have been a number of successful and unsuccessful earnouts across many different industries.
Fidelity National Financial & Lender Processing Services
In 2014, Fidelity National Financial (FNF) purchased Lender Processing Services (LPS) for $2.9 billion. The deal was called an "earnout," which means that LPS would be paid additional money if they met certain financial goals over three years.
The goals were tough, but LPS was able to beat them all. In the first year, LPS's earnings per share increased by 25%. In the second year, earnings per share increased by 30%. And in the third year, earnings per share increased by 35%.
Because LPS beat the goals, they were able to maximize the value of their earnout. FNF had to pay LPS an extra $800 million, which was more than the original purchase price.
The success of the FNF-LPS earnout shows that earnouts can be a good way to make a deal. When the goals are realistic, both parties can benefit.
Microsoft & Nokia
In 2013, Microsoft bought Nokia's phone business. The deal was worth $7.2 billion. Microsoft paid Nokia $2.5 billion in cash and $4.7 billion in stock. But Microsoft also agreed to pay Nokia an extra $1 billion if Nokia met certain goals.
The goals were hard to reach. Nokia's phone business was struggling, and the market for smartphones was changing. Microsoft didn't meet its goals, and it didn't pay Nokia the extra $1 billion.
Some people think Microsoft's goals were too ambitious. If Microsoft had set more realistic goals, it might have been able to meet them and pay Nokia the extra money.
Microsoft's experience with Nokia shows that earnouts can be risky. If the goals are too ambitious, the buyer might not be able to meet them and won't have to pay the seller the extra money.
Earnouts can be a good way to structure a deal, but it's important to set realistic goals.
Coca-Cola & Innocent Drinks
Coca-Cola purchased Innocent Drinks Ltd in 2013. At that time Innocent's founders negotiated an earnout clause that specified additional payments based on hitting targets for sales, profits, and cash flow through 2020. If all those are achieved, it's estimated that the original two founders could earn an extra $100 million for their stake in their company. As this example shows, correctly crafting an earnout agreement can be highly lucrative - but it also requires careful planning and negotiation by both parties involved.
Overall, earnouts can be a great way to bridge the gap between the buyer and seller in an M&A deal. They offer a way to make sure that both parties are happy with the transaction, while also protecting each party from any potential risks.
Earnout structures can add a level of complexity to the sale of your business, which can overwhelm first-time business sellers. This is where Baton can help.
Baton can get you started on the sales process with a free business valuation. That will help you understand if selling your business meets the needs of your “why”. If you’re not ready yet, we can offer some helpful guidance on ways you might increase your business valuation. If you decide the valuation range the market can support would get you where you’d like to be, we can help by introducing you to vetted consultants that specialize in supporting small business sales, and we may even be able to help you find a buyer. Baton is here to make this process as simple as possible. Get started today.