Earnouts – Why an Earnout Pros and Cons

Earnouts are effective tools for closing a valuation gap, to incentivise sellers to further grow profitability post-acquisition or for buyers manage acquisition risk. Earnouts are more commonly employed in higher risk smaller and middle-market transactions where companies have lower “critical mass” (revenue, assets, staff) than larger businesses.

Essentially, earnouts enable parties to agree to disagree and facilitate deals going ahead. They can lower the buyer’s initial cash outlay and offer a form of insurance by reducing the risk of overpaying for anticipated future revenues and profits that do not materialise.

Earnouts can be based on financial or non-financial metrics (or both) but complex earnout structures can lead to conflicted priorities and strained buyer-seller relationships which could adversely affect business performance. Earnouts are typically based over one to three years or even as much as to five years.

Advantages of Earn-Outs:

• Facilitates Agreement: Useful when parties can’t agree on the target’s value or whether anticipated growth will be achieved or even if current performance will be maintained once the seller exits.
• Incentivises Management: Encourages current management or owners to maintain and improve post-acquisition performance.
• Common Scenarios: Often used in deals involving businesses with limited track records or businesses with recent investments in plant and equipment where the benefit is not yet realised, new product releases and related growth and R&D investments which will only be achieved in the future. They can also be used where a business has had a recent setback or have a small customer base or high customer concentration or strong reliance on the skills of the seller.

Disadvantages of Earn-Outs:

• Complex Negotiations: Earn-outs are complex and time-consuming to negotiate. Metrics preferred by buyer and seller can be quite different, for example profitability vs sales even how they are calculated.
• Autonomy Issues: Sellers may want to retain significant influence and continue business as usual making integration challenging for buyers. Buyers may not deliver on promised resources or support growth initiatives. 
• Potential for Disputes: Disagreements may arise over the direction of the business, earn-out calculations, and performance metrics.
• Credit Risk: Earn-outs can expose sellers to the buyer’s credit risk as earnout payments may be unsecured.
• Seller Commitment – seller typically needs to be involved in the business for the duration of the earnout. 

Earnouts enable deals to proceed despite differing views on purchase price but do come with added complexities and risk. It is recommended that the earn-out calculation and metrics are made as simple as possible over short time periods reducing potential conflict and enabling both buyers and sellers to benefit.  In developing the earnout, sellers should factor that all, part or zero of the planned earnout payment will be received.