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From Investopedia, an earnout is “A contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals.”
In essence, earnouts are a tool used to convey a portion of transaction value at some time after the initial closing. The earnout is always a contingency payment dependent on the business eventually meeting a performance metric – in contrast with a loan extended by the seller with a fixed value and terms.
WHEN ARE EARNOUTS USED?
Typically an earnout structure is employed when there is some uncertainty as to the value being conveyed at closing. Situations might include:
- There is the potential for “breakage” – or client loss- as a part of the transaction
- The seller is an instrumental part of the sale process, again causing uncertainty as to post closing sales levels
- The company is introducing new products or services that are not yet fully reflected in the historical financials
- The company has an increasing sales pipeline that the historical financials do not reflect
STRUCTURING AN EARNOUT
There is no hard and fast rule as to how to structure an earnout. Typically future performance is tied to a particular line on the P&L. Examples might include:
- 5x average annual earnings resulting from product line X, paid at year 2
- 30% of gross profit for the year following closing
- 10% of revenues for the year following closing
As a rule of thumb, sellers typically want the earnout metric to be tied to a line “higher in the P&L” – ideally revenue- as it’s the most transparent. Buyers, conversely, typically like to tie the metric to earnings performance, which of course must be carefully defined.
Suppose Company X has been developing a new product line (WidgetLine) that it is ready to bring to market. Based on past experience, the company feels the product will generate an additional $3m per year in revenues and $1.5m in gross profits by year 2.
In approaching a sale, Company X would like compensation for their efforts prior to closing. The buyer, on the other hand, isn’t comfortable paying for those efforts without a clear indication of the scope of value conveyed.
Ultimately the parties choose to use an earnout device to structure a contingent payment based on year 2’s gross profit. For simplicity sake, if the company was originally priced at .5x gross profit, at year 2 the buyer would pay .5x the gross profit from the new product line.
In today’s economy, where rapid changes are commonplace, technology is fast-paced and there is a high degree of uncertainty, an earnout provision may be an appropriate solution to make the deal work. It can be structured as a “win-win” since the buyer is happy to pay the additional purchase price if there is additional revenue with which to pay it. The seller benefits by only sharing in the profit, while the acquirer assumes all of the risk. However, an earnout will only work well if it is carefully structured and fairly benefits both sides of the deal.