Earnouts can be a very effective condition to an offer when buying a business however, they don’t apply to every business for sale. So what exactly are earnouts and when should they be used?
An earnout is when a percentage of the purchase price or an agreed upon amount is paid to the seller at some point in the future, depending upon the business achieving certain milestones or conditions. For example, if the sales of the business hit a pre-determined level within an agreed upon time, the seller gets an additional payment. Now, this doesn’t only apply to sales; it could be a wide array of milestones having to be met, so let’s discuss the more common scenarios when earnouts make sense.
- The business has experienced a recent substantial increase or decrease in sales or profits and a buyer wants to be certain that this trend will continue (if an increase) or not continue (if there has been a decrease).
- The business is reliant on a limited number of clients for a disproportionate percentage of its sales / profits (known as “customer concentration”). The buyer wants to be certain that these customers will continue to buy from the business after the sale, or at least, has a mechanism to not pay for their contribution as part of the purchase price should these clients discontinue doing business with the company after the sale takes place.
- The seller has worked on some large contracts that will only come to fruition after the sale. The seller wants to be compensated for their recent past work, which isn’t reflected in the financials, while the buyer will only pay for this potential if it pans out.
There are four very important things to keep in mind if you are going to use an earnout:
- Keep them simple. If they are too difficult to measure and calculate, it always leads to a disagreement.
- Focus on one metric only, whether it’s revenue, profit, specific customer retention, etc..
- Sellers will be apprehensive about accepting an earnout but they can easily be convinced if a buyer has a legitimate concern.
- Business brokers hate these deal terms because their contracts with sellers usually have them getting paid based upon the total deal value, whereas a seller won’t want to pay their commission on the earnout portion unless it’s realized. However, that’s for the seller and broker to figure out; not the buyer.
So how do you structure the earnout? Let us use the example of declining profits. The business has seen a drop of 25% in the last year. The seller has 101 reasons why. You determine that prior to the drop the business should be valued using a 3 times multiple on $200,000 of Owner Benefits thus yielding a valuation of $600,000. However, in the most recent year (or they are tracking in the current period), the Owner Benefits were $150,000 – at a 3x multiple the value changes to $450,000. Therefore, there’s a $150,000 gap ($600k – $450k).
You offer the seller $450,000 with a $150,000 earnout conditional upon the business generating an average of $200,000 in Owner Benefits over the next 2 years (or whatever period you can agree upon). If the Owner Benefits return to $200,000, the seller gets the additional $150,000. Earnouts do not need to be all or nothing deals. They can be on a scale. As an example in this scenario, Owner Benefits average $180,000 at 3x = $540,000 so seller earns an additional $60,000.
It’s critical that whatever you use as the basis for the multiple to determine what the guaranteed price is (in this case $150,000 x 3 = $450,000), it has to be a figure that the buyer is absolutely comfortable with and will be sustainable after closing.
If done right, earnouts can be an incredibly effective way for a buyer to only pay for what is sure to be the business going forward, and for the seller to be paid if in fact the major buyer concerns aren’t a factor after they take over.