
Earnout
An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings. An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings. 1:07 An earnout is a contractual provision stating that the seller of a business is to obtain future compensation if the business achieves certain financial goals. A disadvantage to the buyer is that the seller may be involved in the business for a longer period of time, wanting to provide assistance to boost earnings or use their previous experience to run the business how they see fit. The earnout eliminates uncertainty for the buyer, as they only pay a portion of the sale price upfront and the remainder based on future performance.

What Is an Earnout?
An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings.
If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1 million plus 5% of gross sales over the next three years.




Understanding an Earnout
Earnouts do not come with hard and fast rules. Instead, the payout level is dependent on a number of factors, including the size of the business. This can be used to bridge the gap between differing expectations from the buyers and sellers.
An earnout helps eliminate uncertainty for the buyer, as it is tied to future financial performance. The buyer pays a portion of the cost of the business upfront, and the remainder of the cost is dependent upon if future performance targets are met. The seller also receives the benefits of future growth for a period of time. Different financial targets such as net income or revenue may help determine earnouts.
Structuring an Earnout
There are a number of key considerations, aside from the cash compensation when structuring an earnout. This includes determining the crucial members of the organization and whether an earnout is extended to them.
The length of the contract and the executive's role with the company post-acquisition are two issues that also have to be negotiated. This is so because the performance of the company is tied to management as well as other key employees. If these employees leave then the company may not hit its financial targets.
The agreement should also specify the accounting assumptions that will be used going forward. Although a company can adhere to generally accepted accounting principles (GAAP), there are still judgments managers have to make that can affect results. For instance, assuming a higher level for returns and allowances will lower earnings.
A change in strategy, such as a decision to exit a business or invest in growth initiatives may depress current results. The seller should be aware of this in order to come up with an equitable solution.
The financial metrics used to determine the earnout must also be decided upon. Some metrics benefit the buyer while some benefit the seller. It is a good idea to use a combination of metrics, such as revenues and profit metrics.
There are legal and financial advisors that can assist with the entire process. The fee for advisors typically grows with the complexity of the transaction.
Advantages and Disadvantages of an Earnout
There are both advantages and disadvantages for the buyer and seller in an earnout. For the buyer, an advantage is having a longer period of time to pay for the business rather than all upfront. In addition, if earnings are not as high as expected, the buyer does not have to pay as much. For the seller, the advantage is the ability to spread out taxes over a few years, helping to reduce the tax impact of the sale.
A disadvantage to the buyer is that the seller may be involved in the business for a longer period of time, wanting to provide assistance to boost earnings or use their previous experience to run the business how they see fit. The disadvantage to the seller is that the future earnings are not high enough, therefore, they do not make as much from the sale of the business.
Example of an Earnout
ABC Company has $50 million in sales and $5 million in earnings. A potential buyer is willing to pay $250 million, but the current owner believes this undervalues the future growth prospects and asks for $500 million. To bridge the gap, the two parties can use an earnout. A compromise might be for an upfront cash payment of $250 million and an earnout of $250 million if sales and earnings reach $100 million within a three-year window or $100 million if sales only reach $70 million.
Related terms:
Acquisition
An acquisition is a corporate action in which one company purchases most or all of another company's shares to gain control of that company. read more
Cash in Advance
Cash in advance is a stipulation used in some trade agreements, requiring that a buyer pay the seller in cash before a shipment is received. read more
Cash on Delivery (COD)
Cash on delivery is a type of transaction in which payment for a good is made at the time of delivery. read more
Earnings
A company's earnings are its after-tax net income, meaning its profits. Earnings are the main determinant of a public company's share price. read more
Escrow : Types, Examples, Pros & Cons
Escrow broadly refers to a third party that holds money or an asset on behalf of the other two parties in a transaction. read more
Generally Accepted Accounting Principles (GAAP)
GAAP is a common set of generally accepted accounting principles, standards, and procedures that public companies in the U.S. must follow when they compile their financial statements. read more
Gross Sales
Gross sales is a metric for the overall sales of a company, unadjusted for costs incurred in generating those sales, as well as things like discounts or returns from customers. It's calculated with a simple equation, where all sales invoices or related invoices are totaled. read more
Like-Kind Exchange
A like-kind exchange is a tax-deferred transaction allowing for the disposal of an asset and the acquisition of another similar asset. read more
Mergers and Acquisitions (M&A)
Mergers and acquisitions (M&A) refers to the consolidation of companies or assets through various types of financial transactions. read more
Net Income (NI)
Net income, also called net earnings, is sales minus cost of goods sold, general expenses, taxes, and interest. read more