What Are Earnouts – A Detailed Explanation With Examples

March 25, 2023 Financial Modeling, Knowledge

What are Earnouts? A commitment between a buyer and a seller of a business is for the seller to receive additional payments to meet the valuation expectation if certain pre-defined targets are achieved by the business. Such payments also remove uncertainty for the buyer. These are commonly seen in middle-market business deals.

What Are Earnouts

Earnout – Definition

An earnout is essentially a contract between a buyer and a seller of a business that states if the business achieves certain goals financially, then the seller will receive additional compensation as an already agreed percentage of gross sales of earnings. This means if the seller is trying to sell the business for a price more than a buyer is willing to buy, an earnout can be made, so if, say, there is a profit of more than 1 million dollars, then 5% of the gross sales should be paid to the seller over the next two years.

Let’s understand deeper

Earnouts is an agreement or a contract that is used in business deals while buying or selling a business or during a merger or acquisition agreement to provide additional earnings to the seller or seller’s shareholders from the buyer if certain business goals or financial goals are met. This agreement is usually used if the buyer and seller are having different opinions about the cash price for their deal. Thus earnouts essentially act as the bridge between seller and buyer. The earnout is dependent on the future financial performance and various financial targets like net income and revenue can help determine earnouts.

From the buyer’s point of view, there are several benefits to an earnout. As the total price to be paid to the seller as per the agreement is based on future performance than solely based on the seller’s projected performance, it minimizes the risk of overpaying for the company/ business by the buyer.

Often times the buyer would want maximum flexibility on how it can operate the newly purchased business after closing, especially as the business environment and related circumstances keep changing. And although it is usually a reason for tension between the buyer and seller, the buyer would not want any hindrance due to covenants, seller protective provisions, excessively harsh restrictions, etc. Also, the earnout works as a motivational tool for the sellers’ management team to continue running the business successfully even after the acquisition is closed.

From the seller’s point of view, the seller would want to receive as much of the cash price of the purchase during the closing of the acquisition.

If there is an earnout involved it can cause the seller to have some concerns such as –

  • whether the earnout milestone targets stated are reasonably achievable within a reasonable period of time.
  • how to make sure that the buyer doesn’t run the business in a way that minimizes or disqualify the earnout payments.
  • what measures will the buyer take to run the business to optimize the probability of earning maximum earnout.
  • how the seller can protect themselves in case of the buyer manipulates the financial metrics of the business so that it affects the earnout payments unfavorably.
  • if there is a delay occurring to pay the seller, then is the total amount of the potential earnout payment significant enough to cause the delay, etc.

Although earnouts are commonly used when the target is to achieve certain financial goals or EBITDA (earnings before interest, taxes, depreciation, and amortization), they can also be structured around non-financial milestone achievements like an increased number of customers or earning a patent or earning approval from the FDA. There was a study conducted by SRS Acquiom in 2017 that studied around 795 private-target transactions and found that:

  • About 64% of deals had earnouts with revenue targets.
  • About 36% of deals had earnouts with some other metrics such as gross margin, sales quota achievement, etc.
  • About 24% of deals had earnouts with earnings or EBITDA targets.

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Earnout Structuring

As this will dictate how the business will be running and all its related key elements, structuring an earnout is very important. A good earnout structure will decide how much the business can earn in revenue, EBITDA, percentage of increase in customers, financial goal achievement, etc. over a course of time which in turn will decide the cash paid to the seller. Some of the features to be considered while structuring an earnout are:

  • Team – The growth and success of the business rely on its efficient team members. As such it is important to have individuals from all sides, which includes lawyers, accountants, consultants who can negotiate specific terms and conditions of the earnout agreement, executives, etc.These people can be considered a key resource to achieving the targeted revenue or EBITDA goals. Typically, 40% is considered as the minimum amount required to keep the seller motivated.
  • Time Period – The reasonable time required to meet the set conditions and goals needs to be decided beforehand. Should it be set for the next financial year? Should it depend on the cumulative EBITDA after a number of years or EBITDA in the second/ third year? The seller usually would want to receive their due payments as soon as possible and might not be willing to wait for a long time as much as the buyer wishes. Hence, in general, earnout agreements are for a short period of time, usually between one to three years. The seller and buyer can renew their contract and renegotiate the terms and conditions if the payouts are satisfactory.
  • Financial Metrics – Financial metrics used in an earnout are generally structured so that it meets the gross revenues, and EBITDA goals, and also include net income and EPS (earnings per share). Sellers will prefer revenue-based earnouts, which are easy to achieve but hard for buyers to manipulate. The sellers therefore may take up projects with low scope for the sake of revenue. Sellers try to avoid EBITDA-based earnouts as they would be worried that EBITDA can be manipulated by buyers by charging additional costs during the earnout period in a way that will benefit the buyer when the period is over. Buyers oftentimes prefer an EBITDA target as they are considered the most reliable indicator of the profitability and value of the business. Net sales minus the cost of goods sold, the gross profit, can also be used as an earnout as a middle ground between buyers and sellers, but sellers are still wary of this feature in the metrics. Hence, a combination of revenue and EBITDA is commonly used for earnouts. But no matter which financial metric was chosen, both parties can still disagree on how the revenues are calculated, or how the expenses are divided. The more complicated the agreement is the less chance of having a disagreement. The common financial metrics are:
  • Revenue – as mentioned earlier, earnouts based on revenue are something a seller would like since they can focus on increasing sales and ignoring expenses. But the issue is that the revenue of a company can grow dramatically while remaining unprofitable.Since sales are not accountable in a revenue metric, the seller can spend heavily on marketing and advertising, or any other methods that drive sales but are expensive. To maximize revenue, the seller may also reduce the price of a selling product, which in turn reduces the profit. The main drawback to using a revenue-based metric is exactly this, profits are affected, although such metrics are least likely to be manipulated.
  • Profit – This can be net income, EBITDA, EBIT, or SDE. Profit-based earnout metrics are very detailed and clearly define what profit means for the deal. The other key features included in the earnout agreement are details of the effect of income taxes, goodwill, amortization, distributions, interest, perks, the non-compete, any other deductions, the effect of capital expenditures on earnouts, etc. The earnout draft also entails details such as the annual income of the seller if the seller is still overlooking the business, if the buyer is operating the business, then profit is clearly stated along with rules that will ensure the business is running to maximize the value of the earnout, if the buyer can amortize the goodwill, etc.
  • Gross Profit – Buyers can choose gross profit-based earnout in deals where the pricing remains flexible. This is most commonly used in industries that are dependent on salespeople. Here the pricing is also pretty flexible. But still, earnout goals based on gross profit are prone to the same issues as that of goals based on revenue. Hence why these are only used in industries where the gross profit margins are critical, or when the business charges custom prices for every job.
  • Royalties – Earnouts based on royalties can pay the seller per unit of the product sold. This method is considered to be one of the simplest ways to measure earnout and is usually employed in transactions where the buyer pays the seller for successful product launches.

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But no matter which financial metric is chosen, there are certain common things to be considered:

  • Measurement of earnouts, GAAP, and modified GAAP must be clearly stated.
  • In case of any bad debts, how will they affect the earnout calculation? Are there any reserves considered in case of bad debt, or are they reduced from final earnings when they are written off? The exact time period before they can be written off should be decided – be it 1 month, 2 months, or 3 months and above.
  • How is the target accounting done after closing? If the buyer should continue with the same accounting policies or is there a need to update the policy? If the earnouts should be based on tax returns or financial statements? If cash-based or accrual-based accounting methods should be considered while preparing the financials?
  • Non-financial Metrics – There are also earnouts based on non-financial targets and milestones since an earnout can be based on the achievement of any kind of milestone, say, certain events or the like. But non-financial metrics should be as clear, detailed, and specific as possible to minimize the risk of future disagreements. Such metrics can include upkeeping of certain key customers, upkeeping of certain key employees, successful product launches, any specific third-party approvals, successful FDA approval, and receiving patents.
  • Minimum and Maximum payments – Sometimes sellers would require a minimum payment in the future to be added to the earnout and in most cases, the maximum payment is also established in the earnout. In case of a minimum payment requirement, the seller will make sure the buyer puts that amount into a legal bond/ contract to ensure that it is paid.
  • A series of payments or an all-or-nothing payment – It should be discussed and established whether a certain target must absolutely be met before the payment is cashed out, like achieving$100 million in revenue by the end of the financial year 2023, or if it can be graduated, like $70 million to $150 million in revenue by the end of the financial year 2023. In the second case, a series of earnouts can be rolled out based on the actual gross revenue met $70 million and $150 million.
  • Dispute Resolution – It should be clearly stated in the earnout agreement how to handle disputes that may arise during the earnout period. Usually, most earnouts are included within the purchase agreement and such earnouts can be subject to dispute resolutions as explained in the purchase agreement. Instead, a separate earnout contract can be drafted differently from the purchase agreement, which will have details of various dispute resolution methods.
  • Protection to Ensure Payment – The seller can put in place some protection clause to make sure the earnout is paid since earnouts are deferred payments of the purchase price. As the cash generated from the business can be used to cover earnouts payment, there is generally a low risk of non-payment. And while sometimes it’s unlikely that a buyer will provide the seller the same protective provisions included in the security agreement and promissory note, other clauses can be included to ensure seller protection. These clauses can also be extended to ensure that while the earnouts remain to be paid, any loan closing or shareholder distribution is prohibited. This also ensures the earnout payments are made a priority before the buyer can reap any benefits from the business.

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As we’ve seen, most structures of earnouts will try to combine different elements like cash, debt, agreements based on employment or customer care, escrows, etc. hence, it’s important to understand how earnouts will fit into an overall deal structure. Before signing a deal, all elements of transactions like earnouts must be divided into contingent and non-contingent components. Most transactions in the middle market tend to be made of primarily three components – cash, escrow, and earnouts. 70-80% of the transaction value is usually cash, and the remaining 20-30% is divided into earnouts and escrows.

Let’s find out how earn-outs fit into the overall deal structure. Here are some basic guidelines to keep in mind about the primary components of the purchase price:

  • Cash – This accounts for the majority in all transactions. The cash down payment can range from 50% to 100%, and rarely will there be transactions below 50% cash down. It can range between 60% to 70% cash down if seller financing is involved.
  • Earnouts – These are rare in smaller acquisitions, coming in less than 5% of smaller transactions. These are not only time-consuming but also rather costly to negotiate and draft. Most often, buyers in the middle market are the ones drafting up the earnouts, even prepared to pay professional advisors accordingly.
  • Escrows – Due to the prevalence of seller financing, holdbacks, or escrows, are less common during smaller transactions.
  • Seller Financing – Seller financing is different from earnouts in that there is a fixed amount and even a payment schedule agreed upon beforehand. Seller financing is usually in the form of a promissory note, generally used in smaller transactions. Around 70-80% of such transactions will have some kind of seller financing. This is a type of non-contingent payment. If the payment is contingent on certain events, it is not a promissory note, it’s an earnout. Due to the right of offset ability, seller financing is used most often than escrows. The right of offset ensures the buyer’s ability to offset compensation for any harm or loss or claims like fraud, false claims of manipulation, material misrepresentation, etc. against the outstanding amounts in the seller’s note.

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Advantages of Earnouts

Earnouts can be beneficial to both sellers and buyers of a business or company. Some of its advantages are:

  • Buyers will have a longer time period to pay for the purchase.
  • The amount of taxes the seller owes will be reduced as the business’s sale is spread over a number of years.
  • For the buyer, the initial purchase price will be much more manageable rather than paying for the business’s full market value.
  • The buyers will have enough motivation to keep the business on top and running well, as they also receive benefits from its success.
  • It is an additional source of income for the seller as they receive continuous payments from the earnouts.

Disadvantages of Earnouts

The disadvantages are as follows:

  • The seller may continue to involve with the business, giving inputs and directions in matters of finance, for a longer time. As such many earnouts will state specifically to eliminate the seller’s influence after a certain time.
  • Sometimes if the company is encountering lower payments to the seller due to lower profit expectations, earnout agreements will also have conditions to protect the buyer from bankruptcy in this case.

Some examples of Earnouts in real life.

  1. A company that makes $5 million in earnings and $25 million in sales is approached by a buyer who is willing to pay $100 million for the company. But the owner is interested in selling it at $300 million. In this case, both parties can come to an agreement with an earnout. The earnout may state that cash payment upfront should be $100 and an earnout of the rest of $200 can be made if sales and earnings reach $100 million within 2 years or $100 million if sales only reach around $60-70 million.
  2. A business that has a value expectation of $50 million according to its owner is approached by a prospective buyer offering $35 as the purchase price, as according to the buyer this is the correct valuation of the business in the current market conditions. Due to the disagreement over $15 million, it was decided by both the buyer and the seller to bridge this gap by using an earnout where the seller will receive some amount of the total price at the time of purchase, and the rest will be paid off based on the earnings of the buyer in a predetermined future. In this case, earnout stated that the seller will be paid $5 million every year for the next three years as long as the buyer can achieve an EBITDA of $25 million every year.

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Frequently Asked Questions (FAQs)

  1. Is there any alternative to earnouts?

Alternatives of earnouts can be performance-related employee bonuses or compensation, contingent value rights (CVRs), or cases where the non-financial goals are more important.

  1. What are the two main types of earnouts?

The two types are – right to fixed payments that are guaranteed and contingent payments that are dependent on achieving a financial milestone.

  1. How is taxing of earnout shares done?

For earnout taxing, IRS may deem earnout as ordinary income if the amount is contingent on the gradual employment of the seller if it is an alternative way of providing incentive compensation rather than considering it as a capital gain of the purchase price.

Conclusion

Hence, we’ve seen how the earnout works as a bridge to gap in the valuation amount of business as decided on by the buyer and the seller. It is a contract upon which the seller will receive a payment if the business does well and achieves various pre-defined goals. The payout level will depend on various factors discussed earlier like the team, metrics used, etc. as there are hard and fast rules in earnouts.

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