If you’ve never come across the term “earnout agreement” before, don’t worry.
It’s a concept often encountered in business sale transactions.
And if you happen to be planning on selling your business, an earnout might pique your interest.
What is an earnout?
An earnout is a financial agreement where the acquirer of your business pledges to deliver a proportion of the agreed-upon acquisition price, contingent on the future success of your company.
Moreover, earnouts act as the bridge between your asking price and the buyer’s proposition.
This is often talked about in the M&A industry. Particularly, when the revenue potential of the target company, in this case, yours, is shrouded in uncertainty.
Typically, an earnout arrangement spells out that you, as the seller, stand to receive additional remuneration over a stipulated timeline. That is if your company hits certain financial targets.
Moreover, this framework offers you and the buyer the opportunity to share in the prospective prosperity of the business. At the same time, it serves as assuage to the buyer’s financial apprehensions.
Think of it as having your cake and eating it too, while the buyer keeps the cake shop’s risks in check.
Payout factors
In the context of an earnout contract, the term ‘payout factors‘ refers to the specific performance metrics that set the guidelines for when and what amount of additional payments you’ll receive.
Such elements might encompass aspects like revenue, SDE and EBITDA, net income, or other fiscal milestones.
Engaging in thoughtful negotiations surrounding these payout factors and delineating them with clarity in the agreement is important.
These elements wield substantial sway over your ultimate financial gain.
More importantly, it’s imperative to establish a clear-cut, transparent process for measuring and reporting these factors.
This transparency will remove any potential disputes or misunderstandings throughout the duration of the earnout agreement—ensuring smooth sailing in your business transition.
Earnout Structure Varieties
Earnout agreements can take on different forms—in other words, customizable.
Both the buyer and the seller can get on the same page with their own preferences and requirements.
Some common elements include:
- Duration: The length of the earnout period can range from several months to multiple years, depending on the business’s nature and the agreement’s goals.
- Payment schedule: Payments can be made on a regular basis (e.g., quarterly or annually) or upon reaching specific milestones.
- Payment caps and floors: The contract may set a maximum (cap) or minimum (floor) amount that the seller can obtain through the earnout, protecting the interests of both parties.
- Clawbacks: In some instances, agreements may include a clawback provision that allows the buyer to recoup a portion of the earnout payments if the business’s performance declines substantially after the sale.
- Escrow: A part of the purchase price might be deposited into an escrow account, to be released to the seller upon achieving certain milestones.
Earnout Agreement: Pros and Cons
Let’s not forget that while an earnout might sound as great as it can be, it also has a fair share of disadvantages.
It’s up to you, the seller, to make informed decisions based on your preferences and have each side of the scale weighed down.
Advantages
- Adaptability: As a business seller, remember that earnout agreements present an agile way to shape your deal, making the bargaining process more fluid and acting as a bridge over any perceived differences in valuation between you and the potential buyer. As a result, this adds a layer of sophistication to your negotiation strategy.
- Sharing the ups and downs: Aligning your financial reward with the future performance of the business isn’t merely a bold move—it’s a balanced one. This approach allows you to share the potential risks and benefits of the transaction with the buyer in a fair and equitable manner.
- Keeping the fire alive: Earnouts don’t just bring cold, hard cash to the table. They act as a powerful catalyst, motivating you to remain actively involved in the business. Your financial prosperity is intertwined with the success of the business, creating a compelling reason for your continued engagement. It’s a carrot at the end of a stick, but one that’s worth chasing.
- Enhanced returns: If your business is thriving—outperforming all expectations—the total compensation you might receive from an earnout agreement can exceed what you’d get from a static purchase price. This could add a silver lining to your business sale adventure.
Disadvantages
- Intricacy: Bear in mind, as a business seller, that earnout agreements are not a walk in the park. They demand your keen understanding of performance metrics and measurement processes.
- Dispute potential: Let’s not rule out the possibility that earnouts can be a recipe for disputes. Issues may crop up when deciphering payout factors or calculating earnout payments.
- Short-term focus: With an earnout agreement, you might find yourself tempted to place short-term profits on a pedestal, potentially jeopardizing the long-term health of the business.
- Unpredictability: And let’s not forget, your final payout is hitched to the business’s future performance, injecting a dose of uncertainty into your financial planning. Needless to say, a buyer wants predictability in a business.
Can Earnouts Improve Goodwill?
Earnout agreements serve as an avenue for fostering goodwill during your business sale, smoothing the ownership transition, and enhancing stakeholder relationships.
Your financial accomplishments, tied to the company’s future performance, encourage your ongoing commitment, fostering trust and confidence.
Moreover, this arrangement also displays your steadfast belief in the business’s future, consequently enhancing its image and signaling stability to potential investors and partners.
In essence, it’s a well-orchestrated plan to leave a lasting positive impact on the company’s goodwill.
Wrapping Up
Earnout agreements serve as a vital instrument to bridge valuation gaps and share risks in business dealings, especially when the future performance of the company in question is a wildcard.
Yet, they’re not without their challenges.
Both you and the buyer must approach the negotiation table with a meticulous mindset. Only by then, you’ll foster a well-grounded relationship and trust from the other end.
We can help you
However, the only problem right now is finding the right buyer for your business.
This is where Tsetserra Growth Partners steps in.
We don’t just acquire businesses—we step into your shoes to continue operating them.
Our commitment extends beyond the deal closure. We understand the immense value of the relationships and reputation you’ve developed over the years, and we’re dedicated to maintaining these ties.
When you choose to transact with us, you’re not just securing a deal—you’re entrusting your business’s future to a partner who respects and upholds your legacy.
Get to know more about our process here.
