How to use an earnout to enhance the sale price of your business
Earnouts allow the seller to earn additional compensation for meeting financial targets
Earnouts give buyers and sellers a compromise tool when they cannot agree on a price
Typically, earnouts require the seller or key leadership to stay with the company
Earnouts can be a flat amount or a percentage of revenue or profits
For best results, earnout provisions should be as simple as possible
Work with an M&A specialist to structure your earnout
When you’re selling a business, the buyer may not want to pay the asking price and you may not be willing to budge on it. In these situations, an earnout can help bridge the gap between the buyer’s and seller’s expectations.
An earnout requires the buyer to pay a certain amount of money over the sale price if the seller meets agreed-upon financial targets. Earnouts are an extremely common provision of mergers and acquisitions (M&A) contracts, and they can strike a varying level of complexity.
To help you decide if an earnout is right for you, this guide explains the basics. Then, it looks at best practices for these contractual provisions.
What does an earnout look like?
Here is a very simple example of an earnout. Imagine Mr. Smith is selling his HVAC company to Ms. Amin. Amin offers to pay $1 million, but Smith believes his business is worth $1.3 million. They compromise with an earnout.
Amin agrees to pay Smith $1 million upfront. If the business meets certain revenue targets over the next three years, Amin also agrees to pay Smith an additional $300,000. The $300,000 is called the earnout.
Alternatively, the buyer may agree to pay a lump sum upfront plus a percentage of the business’s revenue over the next three years. (Note: three years is just a sample number. The contract can stipulate any range of time for the earnout.)
Advantages of earnouts
As indicated in the above example, earnouts are useful in situations where the seller wants more than the buyer is willing to pay. They also offer advantages to the people on both sides of the M&A table.
An earnout helps a buyer to avoid uncertainty. Imagine the buyer is skeptical about how much income the business can earn, so they insist on an earnout. If the business doesn’t hit its earnings goals, the buyer just pays the upfront price. The buyer only has to come up with the additional funds if the business performs as expected. This setup also allows the buyer to spread out the cost of acquisition over time.
On the flip side, the earnout lets the seller claim a piece of the business’s future growth. Rather than walking away from the deal with a flat fee, the seller gets the chance to earn additional money over a set amount of time. Additionally, by spreading out the earnings from the sale, the seller may reduce their annual tax liability.
Disadvantages of earnouts
Of course, earnouts can also come with some disadvantages. For starters, they complicate the contract of the sale. They typically also require the seller to stay with the business for a certain amount of time after the sale to deliver on the earnout promise.
For the buyer, the main disadvantage is that they may end up paying more for the business. But because the additional compensation is tied to financial targets, this tends to be a moot point.
Contractual considerations with earnouts
When deciding how to structure your earnout, you need to consider the following key elements:
Earnout recipients: Which people in your ownership and management team will earn funds from the earnout?
Recipient contracts: How long do the recipients need to stay with the company and what are their roles?
Financial targets: What revenue, profit, or other targets does the company need to meet for the earnout?
Structure of the earnout: Is the earnout a flat amount if a milestone is reached or a percentage of a certain metric?
Time period: How long does the company have to meet the financial targets?
Accounting assumptions: How will the business approach subjective accounting issues?
Although the buyer and the seller both need to adhere to generally accepted accounting principles (GAAP), there are some subjective elements that can affect the metrics being used. To ensure everyone is on the same page, you should outline these accounting expectations before you agree to the earnout.
For example, if you’re selling an HVAC company where you offer warranties, there are different accounting methods you can use to estimate the number of warranties that will be claimed. Similarly, if the new owner purchases capital assets or invests in growth initiatives, they can impact the business’s profitability on paper in ways that can impact the earnout.
Best practices for earnouts
With traditional earnouts, the seller stays with the company during the earnout period. Your performance during this time determines your ability to achieve the terms of the earnout. To that end, you need to ensure you have the right level of control.
If the buyer takes complete control, they may hamper your ability to hit your target. Make sure you have the control and the staff members you need to hit the targets. Also, decide how you’re going to evaluate progress toward the earnout. You may want to have a third-party involved who can act as the referee.
Earnouts can be a helpful addition to an acquisition, but you need to approach them carefully. Ultimately, every M&A deal is different, and you should work with a specialist to ensure your deal is structured in an optimal way. Whenever possible, try to make the deal as simple as you can. This reduces the legal burden and keeps expectations clear on both sides.
Contact SF&P Advisors
At SF&P Advisors, we specialize in M&A with an emphasis on the HVAC and plumbing industry. If you’re thinking of selling, don’t wade into these waters on your own. Instead, lean on us for the guidance you need to set up the best deal possible. To learn more or obtain a free valuation of your company, contact us today.