We have all heard the popular phrase “caveat emptor,” which means “let the buyer beware.” When it comes to negotiating an earnout in the sale of a business, a more appropriate adage might be “let the seller beware.” Depending on how the earnout is structured, an earnout can be quite lucrative for the seller or it can be completely worthless.
It is worth stating up front that we are not generally proponents of earnouts. We have not closed many transactions that included an earnout, unless we believed there was an opportunity for the seller to achieve a superior outcome by structuring a portion of the transaction consideration as an earnout. However, sometimes an earnout is appropriate, particularly in certain types of businesses or industries. For example, in asset management transactions, earnouts are a well accepted structuring technique. That said, there are scenarios in which an earnout may be appropriate and worth exploring.
What is an earnout? In short, an earnout is additional consideration (purchase price) that is paid to the seller at a pre-determined time following the closing of the transaction. Payment is contingent on the company achieving specific goals such as sales, gross profit or EBITDA. Earnouts are commonly used when the buyer and seller have divergent valuation expectations or there are underdeveloped business opportunities that do not warrant fixed consideration (cash or a seller note) at closing. Put another way, earnouts often come into play when there is a sizable gap between the seller’s and buyer’s valuation expectations. For example, say a seller offers their company for sale for $7 million and the buyer believes that fair market value is $6 million. An earnout would provide the seller with the opportunity to “earn” the additional $1 million over a pre-determined timeframe if the company achieves certain clearly defined objectives.
Earnouts are also, at least in theory, a way for sellers to reap some of the benefits of the company’s future results, even if they are contingent on the company achieving certain goals. For instance, an earnout could be based on a specific program, such as a product or service that the seller has been investing in that is just about (from the seller’s perspective) to achieve commercial success. This is one scenario in which an earnout could be used in a positive way, as the seller could derive tremendous value in sharing in the future success of the product or service they had been nurturing prior to the sale. The perceived speculative nature of the product or service would preclude the buyer from paying for that opportunity in cash; however, if the seller is correct and the product or service does become a commercial success, the seller will reap some of the benefit and the buyer will be happy to pay the earnout.
Earnouts are often used as a negotiating tactic by the buyer to help reduce the buyer’s (perceived or actual) acquisition risk. For instance, the buyer may have specific concerns regarding customer concentration, vendor dependence, employees with important customer relationships, or sales and earnings stability. It is likely that the seller does not share this perception of risk. To bridge this risk perception, the earnout would be tied to the company’s future sales and/or earnings with the owner remaining involved with the company throughout the term of the earnout in order to maximize the likelihood of receiving the amounts due under the earnout.
Whether the seller receives any payment under an earnout depends on how the terms are negotiated. It could mean the difference between the seller realizing a terrific valuation (taking into account all of the components of the consideration – cash at close, seller note, and earn-out) for their company, or an earnout that fails to materialize, leaving the seller feeling frustrated and disappointed. Earnouts can be complex and tricky. Thus, sellers should seek input from an expert business advisor early in the negotiation process to assure that the terms of the earnout are well considered and properly negotiated.
Nonetheless, sellers who are considering or who choose to proceed with a transaction that includes an earnout should keep the following in mind:
- Maximize the cash at closing and be satisfied with this amount in the event that the earnout does not materialize. In this context, the earnout becomes bonus purchase price, or “icing on the cake.”
- Make sure that the earnout is achievable and that benchmarks for achieving the earnout are well defined. In addition, the seller should remain active with the company during the term of the earnout and make sure that the goals tied to the earnout are within their control. It is also worth the effort to prepare examples under different cases to confirm that the buyer and seller calculate the value of the earnout identically.
- Structure the earnout so that it is purchase price, not ordinary income. For example, if the earnout is structured such that the seller will be paid $1 million just to remain with the company for two years after the closing, it would be considered compensation and taxed as ordinary income. By contrast, if the earnout goals are related to client retention, sales, or operating income objectives, it would be considered to be purchase price.
- Identify and address decisions that the buyer could make that could jeopardize the seller’s ability to achieve the earnout. For example, if the earnout is dependent on achieving a certain minimum EBITDA, the buyer should not be allowed to layer on operating expenses specifically with the intent to decrease the seller’s opportunity to realize the earnout. Sellers must aggressively identify and address in advance these types of situations in order to maximize the opportunity to realize the earnout.
A poorly structured earnout can cost a seller dearly. Sellers who find themselves in a situation where an earnout is unavoidable should consult with an experienced advisor who can help them structure an earnout scenario that is as “fail-proof” as possible. Of course, the best way for sellers to avoid earnouts altogether is to properly prepare their business for sale so that when the time comes to market their company for sale, the seller is in the best position to demand an all-cash purchase price for their company.
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