What is an earnout?

Edited by Admin
What is an earnout?

In most business acquisition scenarios, there is a gap between the seller’s asking price versus the amount a buyer is willing to pay for it. Sellers tend to be optimistic about the future growth of their business, however, a buyer will be cautious in assuming such forecasts of future profitability.

 

Earnouts are a way of bridging this gap between what a buyer is willing to pay and what a seller believes the business is worth. In an earnout, part of the sale value is paid up front, and an additional amount is agreed to be paid by the buyer at a future date, conditional upon the company’s performance. As an example, if Company A agrees to buy Company B for a total value of $5 MM, of which, $1 MM is in the form of an earnout conditional upon revenue and EBITDA growth, this means that the owners of Company B (the sellers) will only receive the additional $1 MM if the company hits the target revenue and EBITDA growth numbers. If not, the final value of the sale will be $4 MM.

 

Earnouts are often used by buyers to hedge their risk and avoid overpaying for a business. Earnouts also incentivize the seller to remain involved with the business through the transition phase and facilitate a smoother change of control.

 

The limitation with earnouts is that when a new management steps in, it could make operational changes which could result in the company not achieving the earnout targets. In addition, when the acquisition is strategic and the buyer integrates the target’s operations with its own, it is difficult to measure whether the growth was due to the buyer or due synergies from the acquisition. Consequently, earnouts can get extremely complex. Sellers must carefully examine all earnout terms to make sure that they are measurable and realistic. For this purpose sellers often consult professional M&A advisors and legal counsel.