Earnouts: Part 1 - Why and when?

“Forget about any earnout payments. Just assume that you’ll never see a penny of that money.”

I got that advice from my board director when I was negotiating on price early in my exit.

He’d been around the block on many deals, and seen the earnouts go wrong more often than not.

Agreeing to an earnout is often the biggest regret for a company owner who has sold. You pop the champagne, anchored on the total price that you have sold the company for, and count on getting paid all of it... Then you end up with far less.

Earnouts are one of the most common deal structures in company exits. Around 30% of private company sales include an earnout of some kind, and its even higher for startups.

Here’s a three part series on earnouts, broken up as follows:

Part 1: Why and when they are used
Part 2: The mechanics and worked example 
Part 3: When things go wrong, and how to avoid getting screwed

Let's get into it...

What is an earnout?

Some of the purchase price is held back, and only paid to the seller if the company hits targets after the deal.

So the seller gets some money upfront when the deal closes, and maybe another payment (or multiple payments) later depending on how well the business does.

The target is usually financial (revenue, EBITDA or a combination), but can also be based on other targets like getting a certain regulatory approval.

There are many ways an earnout can be structured… we will get into that in Part 2.

Why are earnouts used?

Earnouts do two things really well.

1) Help buyer and seller meet on price

Often, a deal will stall because the seller wants a higher price than the buyer will pay. That creates a deadlock.

So how do you bridge the gap in valuations?

The buyer says: “I’m sorry, I can’t pay that much for the business. But I can pay this much up front, and if the business does as well as you predict I will pay you the rest.”

That’s an earnout.

It forces the company prove its value to get paid the amount they are asking for, and pushes some of the risk on valuation to the seller.

As a seller, if you are confident in the health and prospects of the business, you might want to take that deal.

2) Keeping the seller engaged

If sellers are heavily involved in management of the business, the buyer will want to keep them motivated.

That’s hard if you’ve just made someone a multi-millionaire and they no longer have any 'skin in the game'… they are more likely to spend their day looking at yachts than keep hustling to grow the business.

Holding back a chunk of the sale price and making that contingent on future performance is a great tool for buyers.

When are they used?

There are some factors that mean your buyer is more likely to require an earnout, and want to put a larger proportion of the total price into the earnout.

It all comes down to risk.

• If your business has uncertain future performance. That might be because you are a start up with a short track record, or because you’re in an industry with volatile cashflows (like pharma).
• If your success is contingent on a single future event, like a key regulatory approval (like FDA approval for a drug).
• If you are asking for a very high multiple. If you are growing very fast and are asking for a high multiple, that puts a lot of pressure on future performance. So a prudent buyer will ask for an earnout to protect against over-paying if the growth doesn’t come as planned.
• If the sellers are critical to management

Why would a buyer want one?

As we covered above, it helps to de-risk the purchase price and keep seller management active in the period after the deal.

But there are some other ancillary benefits for buyers too.

If helps to defer their payment until later, which might help with financing costs. They can use the profits from the company after the deal to fund any earnout payments. It can also help to get the deal approved by their board or shareholders, as the risk profile is lower with an earnout.

Lastly, pushing for an earnout is a great way for a buyer to test the sellers’ forecasts. When it comes down to it, do the sellers really ‘back themselves’ to hit the numbers in their forecasts? Or do they suddenly get coy...?

There’s a key lesson in here. When you are building out your forecasts, be careful of pushing the numbers too far… the buyer might call your bluff. Read more in Goldilocks Problem: How to get your forecasts 'just right’.

Why should a seller accept an earnout?

On the face of it, earnouts look like a bad deal for sellers. Obviously, you would prefer all the money up front with certainty.

But there are benefits to being open minded to an earnout. 

If you really believe in the prospects of the business, it will help you get a much higher price than insisting on all the money up front. You take some risk, but in return the upside could be great.

And being pragmatic…if you have a short track record or uncertain cashflows, you might need to just accept that any rational seller will need an earnout.

Are there alternatives?

The alternative is a partial sale, which has similar features.

Instead of selling 100% of the business, you sell a proportion (usually a majority like 80%) and keep ownership of the rest. That means that the buyer doesn’t have to pay the full price up front, and you are motivated to keep growing the business.

More on that here - Exploring five M&A deal structures.

Can I just say no?

You can just push back entirely on an earnout, and force the buyer to pay you all of the price up-front.

That might work if you have some strong competitive tension, with many buyers competing to buy you. And you will need to avoid the factors listed above that make earnouts more likely.

The most likely outcome is that you will get a lower price, but have all of it guaranteed and paid up front. Depending on your views on the future of the business and your walk-away number, that might be a better deal for you.

What are the risks?

We will dive into this in detail in Part 3.

There’s a big chance you might never see the future payments. There are many things that can go wrong that mean you don’t hit your targets — things in your control and outside events too.

And remember you are no longer the owner of the business, the buyer is. So they might hinder you from hitting those targets. That’s why earnouts are the largest source of litigation between buyers are sellers.

There are many levers that you can use to de-risk the earnout that we will get into, giving you plenty of pragmatic tips.