What is an earnout?

In plain English here is what an earnout is…

An earnout is a contingent part of the sale and purchase price of a business. The payment of the earnout is generally paid over a few years and linked to certain success factors that need to be met by the seller. Common criteria of an earnout are sales targets, customer retention, patent approvals, and maintained profit margins.

It’s quite common for an earnout to come in the final hour of the sale where the buyer basically takes a portion of the purchase price and springs it on the seller to carry it over a certain term with stipulations. The offer amount in the letter of intent may have looked good for the seller, but it might not look so good when the buyer says a significant portion of it is contingent on the future performance of the company.

Once the business exit ball is rolling it is extremely difficult to slow it down. The sunk costs mentally and financially make it hard to back away from the deal, so you need to be strong and really make the effort to push back on any earnout on the offer, if you can.

Is it really going to pay off?

A buyer gravitates towards an earnout for several reasons:

1. Mitigate their risk of not achieving the future cash flow projections they were sold. Even if they believe they can hit their company targets without the earnout it is still in their best interests to put a contingency on some of the investment.
2. Reduce the capital necessary to complete the transaction, turning it into a form of seller financing. The buyer can use their capital elsewhere, making the deal more practical and appealing.
3. A third, and dangerous reason for a buyer to push for an earnout is to intentionally pay less than market price for a business because the buyer knows there is little chance of hitting the criteria put in place.

Why do earnouts go bad?

• When the projections are inflated and there are too many assumptions made surrounding the execution and integration of the new products and services.
• Culture clashes with people, processes, and vision make it difficult to continue on the path originally set before the acquisition.
• Control of timeframes, key staff, and goals can easily be modified by the buyer with little input from the original owner.
• All of a sudden there are rules, bosses, and processes to follow and entrepreneurs generally hate being employees. Politics, organizational dysfunction and conflict arise from the new arrangement and derail the probability of hitting the goals.

Not all earnouts are bad of course, but before accepting an earnout offer you should:

Ask yourself the following questions:

1. Is the up-front dollar amount enough money before you get the earnout? i.e. would you still be happy if you didn’t get the rest of the money?
2. What is the true motivation of the acquirer? Are they really rooting for you to hit your numbers?
3. Why are they asking for an earnout? Lack of capital or lack of trust in the future projections perhaps?
4. What impact do the reps and warranties have on you successfully hitting the earnout?
5. Can you successfully, and happily, work for someone else as an employee?

Key takeaways:

• Be able, and willing, to walk away if the deal doesn’t look exactly like what you want it to.
• Get as much up front as possible.
• Be okay with the upfront number as your only payment and treat the earnout like the icing on the cake.
• Know yourself and think about what it will be like working for someone else.

What else you should avoid?

14 Top Seller Mistakes