Earnouts are a great way to build confidence, maximise price and reduce buyer risk. Although often overlooked in smaller transactions, earnouts are becoming increasingly popular in business deals over the one million dollar mark as more people become confident with the process. Earnouts are the primary tool when the seller and buyer can’t agree on a business’s sale price.
An earnout is a deferred payment structure that forms part of the condition of sale, with the payment or payments tied to the business’s future performance. What the actual performance relates to becomes part of the earnout terms. For example, the performance can be linked to revenue, EBITDA, or a non-financial metric such as retaining key employees, extending critical contracts, or issuing expected patents.
So who benefits more from an earnout? Well, the answer can either be the buyer, the seller or usually both. First, let’s look at some of the advantages. When buying any revenue-producing asset, whether it is bonds, shares, real estate or business, the return on investment is always tied to risk. The riskier the asset, the higher return.
Therefore, when you consider only about 50% of small businesses make it through their first two years, buying a small business (the ATO defines a small business with less than $10,000,000) in turn over) can be daunting for the risk-averse. Implementing an earnout helps alleviate some risk by protecting the buyer’s purchase price if the business does not perform as promised by the seller. A typical example is when the seller believes their business is worth more than the buyer. However, if the company performs as promised, the buyer would happily pay the total amount, so structuring payments through an earnout is the perfect solution.
Payments are released when the business hits performance targets over the next 6 – 24 months; if the company falls short of those targets, the buyer pays a percentage of what’s owed. Earnouts are an excellent tool for creating alignment between the buyer and seller, mainly when the seller will remain with the business after settlement to run the company. They’re also a great tool to reduce tax burdens incurred upon settlement.
Other advantages of an earnout are that it puts a price tag on potential, acts as a deal catalyst for bridging perceived valuation gaps, can help put a framework around uncertainty, and creates alignment between buyer and seller.
However, just because the concept of an earnout is simple, properly creating and drafting an earnout is difficult. The primary disadvantage of earnouts is that either party can easily manipulate them. If the seller is in charge, the seller can do the exact opposite by neglecting the long-term strategy and making high growth, high-risk projections on the earnings by focusing on the short-term. The seller could also run aggressive marketing campaigns or loosen trade credit to customers to attract new business.
A buyer can deflate the earnout amount by overspending on R&D, advertising, marketing, product development, excessive salaries to “insiders”, and so on.
Buyers may wish to eliminate certain duplicate functions in the business, such as accounting, legal, and HR. Earnouts make integration difficult, frustrating the buyer and handicapping them operationally. The only solution is to allow the business to remain under the buyer’s control or to establish rules and standards by which the company operates. If the targets outlined in the earnout are not met, the seller may question the buyer’s management team’s abilities, leading to further disputes. The larger the earnout, the greater the divide between the seller and the buyer.
To address the possibility of manipulation by either party, earnouts must be meticulously drafted. It may be difficult for a seller to police the business once the buyer is in command. The earnout is more susceptible to manipulation if the buyer knows they will not be closely monitored. Earnouts should not be used to avoid contentious valuation issues and should be reserved as a last option.
In conclusion, earnouts split the total sale price into portions that are contingent on the occurrence of future events that could affect the value of the business. They allow the buyer to pay more to the seller while reducing risk. They only succeed if all parties act in good faith, continue with sound business practices and operate within a well structure earnout framework.