The ABCs of Earnouts
Learn about the advantages and disadvantages of this structuring tool used primarily to bridge a valuation gap.
What’s an earnout? An earnout is that portion (generally 10–35%) of the purchase price for an acquired business that is contingent upon the business achieving certain milestones during a specified time (typically one to three years) after closing. The contingent purchase price is "earned" when the acquired business achieves the milestone. If the milestone is not met post-closing, the buyer makes no earnout payments to the seller.
Earnouts are not the same as purchase price adjustments. Unlike earnouts, a purchase price adjustment may increase or decrease the purchase price.
So, what do earnouts accomplish? First, let's understand what they do best — bridge a valuation gap.
Bridging the Valuation Gap
Earnouts are a useful tool to bridge the valuation gap between a buyer and seller in the following instances:
- Turnaround situations where the seller will likely argue that historical financial results are not an accurate measure of the value of the business; very common in today’s uncertain markets.
- Businesses that have developed new product lines that have not been proven in the marketplace.
- Hot market sectors where a difference in perception of value exists.
- Entrepreneurial stage companies where the entrepreneur has an inflated perception of value.
Advantages of an Earnout
When structuring transactions with earnouts, these are some of the key advantages that usually come up:
- If the seller continues in the business post-closing as the seller-manager, an earnout incentivizes the seller to continue to be involved in the business and facilitates the transition to the buyer.
- Provides the buyer with a form of acquisition financing by reducing the amount of consideration delivered at closing and, thus, eliminating the costs associated with third party financing.
- An earnout gives the buyer a source of offset for future indemnification claims.
Disadvantages of an Earnout
However, there are some disadvantages to structuring earnouts such as:
- The seller-manager may not have sufficient control to manage the business post-closing in order to achieve the earnout, particularly if there is not separate accounting for the acquired business.
- From the buyer’s perspective, the earnout arrangement may incorrectly motivate the seller-manager to focus on short-term goals, as apposed to a long-term integration strategy of the acquired business.
- Earnouts create opportunities for disputes and litigation surrounding the interpretation of earnout terms or the operation of the acquired business during the earnout period.
Earnout payments are typically based on the business reaching post-closing financial milestones tied to one of the following top-down income statement metrics: revenues, gross profit, EBITDA, pre-tax income or net income.
Because of control issues, sellers prefer the metric be toward the top of the income statement (e.g., revenues). On the other hand, buyers prefer the milestone be toward the bottom of the income statement in order to capture the costs associated in achieving the milestone.
They can be extremely difficult to manage given how the milestone can be impacted by other matters, such as capital requirements, sharing of resources and accessing the buyer's infrastructure during the earnout period. Earnouts should be structured with these elements in mind to avoid confusion and conflict between the buyer and seller.