Deal professionals will tell you to avoid them, yet many deals include them
When you sell your company one day, you of course want to receive the purchase price offer by the acquirer in an all cash at closing transaction. Then why do so many deals involve an earnout?
What is an earnout? It’s a mechanism used in mergers & acquisitions where the acquirer establishes a plan for the seller to earn some or all of the purchase price for the company at a future date, based on future performance. In other words, the acquirer is going to take ownership of your business but you’re going to have to meet certain performance requirements before they will pay you all that you expected.
What is an earnout? It’s a mechanism used in mergers & acquisitions where the acquirer establishes a plan for the seller to earn some or all of the purchase price for the company at a future date, based on future performance. In other words, the acquirer is going to take ownership of your business but you’re going to have to meet certain performance requirements before they will pay you all that you expected.
Sounds like this greatly favors the acquirer and not the seller and you’re correct. So then why are earnouts so common?
There are generally two reasons acquirers will turn to using an earnout in their offer. One reason is to bridge a gap between what you believe your business is worth and what they do. The acquirer will make a cash offer for the amount they believe your business is worth but then bridge the gap with an earnout that allows you to potentially earn the difference in subsequent months or even years. Another reason they will use earnouts is if they see a risk in your business and they aren’t willing to accept all of it and want you to continue owning some. They might believe there is risk in your growth forecast or there might be a meaningful customer or contract that is up for renewal in the near term and losing it could impact your business so the acquirer has you share in the risk with the use of an earnout until you know whether the renewal will occur.
Generally, earnouts are disliked because sellers will often tell you they didn’t receive their earnout so the portion of their exit payout was never received. They are also disliked because there could be confusion over how the earnout will be managed and calculated, leading to potential legal disputes post transaction. But, acquirer’s have to represent their best interest and those of their shareholders and earnouts can be a useful tool for them. But here is the key – as part of your exit preparations 2 or more years in advance of trying to exit, prepare to present a business that has low risk so you can take away the reasons an acquirer will want to use an earnout model.
Contact us and we can help you identify where there is potential risk in your business and help you identify steps you can take to either eliminate or at least minimize it.
