What are earnouts, why are they used? Earnouts maximise value for the seller of a business and de-risk the transaction for a buyer. Businesses are valued and priced by a buyer largely on past performance (although internally a buyer will have a value based on future performance) whereas a seller who understands the prospects and opportunities of the future will see this as a key determinant of the price. The earnout is a mechanism used to bridge the gap to achieve an agreed price based on future performance of a business.
The earnout may be over two to five years, the seller may or may not be involved in the future of the business or may have a different role, all of which adds risk to the seller.
Measuring an earnout is generally complex, buyers would like multiple variables addressed from the top to bottom of a P&L and add balance sheet targets for good measure. The seller typically prefers a far more simple measure – top line sales. Invariably as the earnout variables move from sales to margin to EBITDA or after tax profit, the measure becomes more difficult to manage.
Company accounting practices may change to align with the buyers structure and format which makes the consistency of results questionable and difficult to maintain. In some instances the earnout can include variables such as new product releases, entering into new markets, head count increase or decrease; these are very difficult to measure, manage and are complex.
The earnout can also be negatively impacted with promised capital expenditure not happening or being delayed. Synergies agreed to may not be realised, resources may not be made available for various reason resulting in missed targets.
A further risk to the seller is to ensure that the buyer actually makes the earnout payments, that they are paid within the specified time and do not try to renegotiate and change the earnout and whether they do have funds to make goo on the payment (suitable escrows may be necessary).
Earnouts Maximise Value but Add Complexity
Although earnouts have many detractors and are fraught with complexity (often only truly understood well after the ink on a sale contract is dry), earnouts do remain a favoured mechanism for buyers to mitigate risk and optimise price; for sellers, earnouts maximise value for their business sale (over time).