Earnout: Everything You Need to Know
An earnout is a provision in a purchase agreement or it can be a separate agreement that's part of a group of transaction documents in a merger or acquisition.5 min read
What is an Earnout?
An earnout is a provision in a purchase agreement. It can also be a separate agreement that's part of a group of transaction documents in a merger or acquisition. It makes part of the purchase price dependent on the startup company reaching certain milestones within a specified time. When the company reaches the milestones, the seller gets the earnout in stocks or cash. Earnouts are popular among private equity investors who might not be able to keep a business running on their own after a purchase. They usually defer between 10 and 50 percent of the purchase price.
Reverse Earnout: What is it?
A reverse earnout pays the buyer an amount or percentage of a performance target. The payment is reduced if the target is missed, so it's the reverse of a standard earnout.
Why is an Earnout Important?
Earnouts make businesses more appealing to investors since they can pay for part of the company with future profits. This lets sellers ask for a higher total price than the amount they could get in a lump sum while protecting buyers from overpaying. Some sellers can make money from buyer renovations after a purchase through an earnout.
An Earnout has the Following Advantages:
- Earnout provisions reduce risks for buyers and increase potential rewards for sellers. In most agreements, the seller gets a bonus if the company is more successful than projections.
- They help bridge the valuation gap between sellers who want a higher price and buyers who want a bargain or who are skeptical or low on cash.
- An earnout encourages a smooth management transition by giving the seller an incentive to keep managing the company with the buyer or run it on a stand-alone basis for a certain period. That way, the seller can increase his or her chances of getting the earnout.
- An earnout lets the seller enjoy some of the benefits of future growth.
- They give buyers and sellers more flexibility.
- Earnouts encourage sellers to improve companies for buyers.
- Improvements made by the seller could generate enough money to pay for all or part of the earnout. That way, the buyer will have cash available for payments.
- Company shareholders get their money after the earnout is achieved, so they can also save by deferring income taxes related to it.
Problems with Earnouts
- If the company doesn't meet the milestone, the seller could work for years without receiving the earnout.
- If the earnout period is too short, the seller could sacrifice the long-term goals of the company for short-term gains and their earnout.
- Even if sellers are successful, they must give up time and potential profits from their next venture.
- Earnouts often lead to disputes between the buyer and the seller over payments, payment times, or how to run the company.
- The buyer must leave the company as a separate operating unit so that the management has a chance to achieve the earnout. Otherwise, the seller could sue the buyer for impairing their chance to complete the earnout.
- Many sellers require that buyers support the business with their existing companies through marketing, capitalization, or sales force. This makes negotiating an earnout difficult and complex.
- A seller could focus on nothing but completing the earnout, exposing the company to more risk.
- Sellers can ignore requests from buyers because most sellers can't be fired until the earnout period is over.
- Sellers often have limited control over the company and less access to records.
Terms You Should Know
- EBITDA indicates a company's performance. It stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
- GAAP stands for generally accepted accounting principles. Buyers and sellers should agree on accounting practices for the company together. Many even hire an accountant together since disputes often start when accounting doesn't match. However, managers must still make judgments that affect results. If a change in strategy impacts results, the seller should be prepared to find a solution.
- Amortization is just another word for paying off a debt in installments or spreading out expenses for accounting and tax reasons.
Some Earnout Examples
Earnouts are usually a percentage of gross sales or earnings. For example, an investor could buy a startup for $1,000,000 plus 5 percent of gross sales over the next three years. The level of the earnout depends on the size of the business in three years and all the other provisions in the agreement. Some agreements give sellers some money even if they don't reach their milestones. While some earnouts are paid in installments, others are paid at once. Payments can be cash or stock, but stocks have tax advantages.
In another example, a company has $500 million in sales and $50 million in earnings. A potential buyer is willing to pay $250 million, but the owner believes the company has excellent growth prospects. He asks for $500 million and they compromise with an upfront cash payment of $250 million and an earnout of $250 million if sales and earnings reach $1 billion within a three-year window or $100 million if sales only reach $600 million.
Tips for Negotiating and Using Earnouts
- Keep all terms simple and consult a lawyer experienced in mergers and acquisitions.
- Sellers should include a provision that accelerates the earnout payment if the buyer sells the business, another company takes over the buyer, or the seller is fired without cause. Sellers should also keep as much control over the business as possible to increase their chances of getting the earnout.
- Buyers should include a cap on the earnout amount to reduce expenses.
- In a merger, both parties should have a way to measure their performance independently to avoid earnout disputes.
- Sellers of companies that usually meet or exceed performance predictions will have a negotiating advantage.
- According to Mayer Brown, agreements should include an arbitration clause to prevent litigation.
- An earnout could be a security. You should assume your earnout is a security if it comes in a certificate or instrument, grants voting rights for the company, or pays dividends.
- To avoid conflicts, don't use earnouts when dealing with friends or family members.
- Track progress toward the milestone.
- Add a provision to keep key employees and a plan for emergencies like natural disasters.
- Buyers and sellers should agree on the length of the contract and the executive's role with the company post-acquisition.
- Decide whether to extend the earnout to company board members or other crucial employees.
If you need help with your earnout agreement or other parts of your merger or acquisition agreement, you can post your question or concern on UpCounsel's marketplace. UpCounsel only accepts the top 5 percent of lawyers to its website. The site has a diverse selection of the nation's best startup attorneys. You can easily find a lawyer to help you negotiate or advise you about other aspects of your business. Lawyers on UpCounsel come from excellent law schools like Harvard Law and Yale Law. They have an average of 14 years of legal experience, and many work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.