When selling a business, an earnout is essentially a commitment by the buyer to pay the seller a certain amount of money tied to future performance after a sale. While this method is a great way to boost the value of a company, it can be a risky proposition for a seller.
In many cases in the M&A world, earnouts are used as a last resort to bridge the gap between the seller’s expectations and what the buyer believes the company is worth.
Below Are Some Examples Where Earnouts Can Be Useful:
- When there are contracts at risk of not renewing.
- New contracts where the seller wants a share of the profit for efforts in obtaining the contracts just before closing.
- When the buyer is concerned about major customers leaving.
- Loss of key employees.
- Projected revenue goals not being reached.
Sellers want to be paid. Buyers want to pay based on realized value for the business.
There Are Ways to Structure Deals to Reduce Seller Risk, Such As:
- Sellers don’t want a deal to be tied to cash flow, as the bottom line can be manipulated.
- Buyers don’t want a deal to be tied to revenues, as a sales team can rack up sales at razor-thin margins.
We recommend tying an earnout to gross profit with a clear understanding of what is to be included in the cost of goods. This way, the buyer gets a firm margin, while the seller has assurance that the numbers cannot be manipulated.
For a seller, the willingness to accept a reasonable earnout sends a signal of confidence to the buyer. This can reduce a buyer’s fears and help get a deal across the finish line.
So, if you hear the word “earnout,” keep an open mind. It could be an opportunity to gain additional value from the company, especially if there are unique circumstances or there is potential upside that would benefit the new buyer.
