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Earnouts Explained: Definition, Pros, and Cons

Think of it as having your cake and eating it too, while the buyer keeps the cake shop's risks in check.
what is an earnout
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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.

Let’s explore what is an earnout.

What is an earnout?

An earnout (commonly known as an earn out agreement) 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’s financial targets.

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. And it’s formally known as contingent consideration. 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 future payments over a stipulated timeline. That is if your company hits certain financial targets.

Moreover, this framework offers you, the business owner, 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.

Key Takeaways

  • An earnout agreement is a financial arrangement where a portion of the purchase price of a business is paid based on future performance.
  • Earnout agreements help bridge the gap between the buyer’s and seller’s valuation of the business, especially when future performance is uncertain.
  • The terms of an earnout agreement, such as duration and payment schedule, can be customized to suit the needs of both the buyer and the seller.
  • Earnout agreements can motivate the seller to stay involved and contribute to the success of the business after the sale.

Earnout 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 growth, 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 expected growth.

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

An earn out agreement can take on different forms—in other words, customizable.

Both the buyer and seller can get on the same page with their own preferences and requirements.

Here are some key considerations to look after when going all-in with earn outs.

Headline Purchase Price

Also known as the full buying cost—the entire sum that’s headed into the seller’s pocket.

The buyer, if they already know about the seller’s price tag and are keen on holding their ground in negotiations, will generally match their total purchase price to that price tag.

Now, here’s the interesting part—this move communicates to the seller that the buyer wants to close the valuation gap in full, creating a window for the seller to earn what they’re asking for. But sometimes, the buyer might not be up for covering the whole valuation gap.

Instead, they might decide on a total purchase price that falls between 70% and 80% of what the seller is asking.

Initial Payout

You could say it’s an upfront payment.

Oftentimes, this is where you should anticipate what the portion of the purchase price is.

Now, looking at it from the buyer’s viewpoint, the initial payout shouldn’t exceed their estimation of its business value. It’s an essential element here—it’s the amount they’re putting on the line.

In simpler terms, it’s capital in the danger zone that could vanish if the target’s performance is so subpar that the value falls short of the initial payout.

Buyers often aim to reduce their initial payout, going below their estimate of the enterprise value, thus narrowing down the danger zone.

Contingent Payout

This is the leftover amount from the total purchase price once the initial payout is taken out of the equation. It’s like a safety net, a portion of the total price that’s dependent on certain conditions being met.

Moreover, it provides an added layer of security for the buyer, as it allows them to hold back a part of the payment until the seller fulfills their end of the bargain.

This ensures the buyer isn’t putting all their capital at risk upfront.

Earnout Period

Now, an earn out period usually spans from one to five years, with three years being the most common.

And because it is long-term, these questions are often overlooked by many business owners:

  1. Will you have the same autonomy beforehand?
  2. Can you still retain customers and key employees?
  3. Can you control the budget?

I’ve observed that the length of the earnout period should strike a balance—it needs to be extensive enough to allow the remaining management team just the right amount of time to reach their objectives.

Yet it shouldn’t be so stretched out that it leads to goal fatigue or loss of motivation.

Keep in mind, if the seller operates the company during the earnout duration, the earnout might be viewed as a salary rather than a capital gain.

Let’s say, for instance, a buyer and seller reach a consensus on the business’s purchase price of $1,000,000.

The seller might agree to recover this price over a span of five years, rooted in a proportion of the business’s net profits, with an annual payment not falling below $200,000.

Future Financial Performance Metrics

Performance metrics fall into two buckets—financial and operational.

Financial metrics usually focus on revenue or profit aspects. These types of metrics may be tricky to evaluate depending on the type of purchase that is taking place.

In the case of a target company is fully merged with the buying company, the standalone profit profile after blending might be hard to distinguish. For an easier approach, try using the Times Revenue Method.

On the other hand, profit-based metrics like SDE or EBITDA are preferred when the target firm continues to operate as an independent with its own distinct financials.

Operational metrics, typically tracked via set milestones, are also common. These metrics can often be benchmarked by new product development significantly boosting the target firm’s value or entering into new markets.

Payment Options

In terms of payment options, there are generally two routes you can take:

  1. Multiple, phase-wise evaluations and payouts, typically annually or even more frequently.
  2. One-time evaluation and lump-sum payment, usually at the end of the earnout period.

Drawing from my professional experience, I’d typically caution against the multiple evaluation/payment approach.

Why? It’s because this process tends to brew up considerable stress, disputes, and distractions for management. Despite this, sellers often lean towards smaller, more frequent milestones and payments.

Their motive is quite clear—it helps stage and lessens the potential blow to their operational risk.

Beyond the payment frequency, we also have to nail down the evaluation method:

  1. Tracking the financial performance growth rate from the date of acquisition to the end of the earnout period.
  2. Setting an absolute value target to be achieved between the acquisition date and the end of the earnout period.

Contingent Payout Formula

Finally, we need to figure out the target metric (that is, the performance level) and the related earnout payments that correspond with this level of performance.

In total consideration, it’s important that the structure allows rewards for the target firm’s partial performance, even if it doesn’t fully hit its performance goals.

That’s why an escrow agreement is often recommended to hold funds that are contingent on the acquired business meeting certain future performance metrics.

In simple terms, an all-or-nothing approach is hardly the norm. It’s all about crafting a structure that caters to varying degrees of performance.

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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

  1. 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.
  2. 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.
  3. 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.
  4. 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

  1. 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. 
  2. 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. 
  3. 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. 
  4. 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.

Frequently Asked Questions

What are the primary goals of earnouts?

Earnouts aim to align buyer and seller interests, incentivize post-acquisition performance, and manage valuation disagreements.

How are earnouts typically structured in terms of financial metrics?

Earnouts are often tied to metrics like EBITDA, gross revenues, or specific business milestones.

What are the alternatives to earnouts?

Alternatives include upfront payments, stock options, or deferred payment structures.

What factors affect the likelihood of an earnout being included in a transaction structure?

Factors include valuation disagreements, perceived business risks, and the seller's future role in the business.

When should earnouts not be used in a transaction?

Earnouts might be avoided when both parties agree on valuation or when potential for disputes is high.

How can a seller prevent an earnout from being manipulated by the buyer?

Sellers can include protective clauses, ensuring transparent accounting and business practices post-acquisition.

How can disputes related to earnouts be resolved?

Disputes can be addressed through arbitration, mediation, or, in some cases, litigation.

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.

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