An earnout is deferring part of the sale price of the business to a post-closing payment that is based on the performance of the business after the sale. It is common in larger business sales where the seller stays on with the business after the sale. In these business sales, it is an incentive for the seller to be motivated to manage the business well.
It is not uncommon to see an earnout made part of an offer in the purchase of a small business. However, in most of these business sales, the seller is not staying on with the buyer for any extended period. In most small business sales, the seller leaves shortly after the transition to the buyer.
When is an earnout appropriate and when is it not? Owning a business has risks. That is a big reason why the owner gets a much higher return on his investment than putting his money in the bank. Some buyers who are looking for a business to buy propose an earnout because of this risk. Some of these buyers have a background in the m & a field and have seen earnouts used in larger deals. However, if the risk in the deal is normal business risk, and the seller is leaving the business, the amount the seller is paid should not depend on an earnout. The buyer is managing the business and needs to accept the business risk.
When is an earnout justified? When there is risk that is more than normal business risk and peculiar to the business being sold. Some examples:
- Concentration of sales – a high percentage of the revenues come from one or a small number of clients.
- Key employee – the business would suffer if the employee left. This is common if there is a key salesperson.
- Industry risk – if the industry is in decline and customers are switching to alternative sources or going out of business.
- Key supplier – if a high percentage of the sales are from one supplier, who cannot be replaced, and the loss of the supplier would hurt revenues significantly.
- Distressed business – if the business is at great risk of going out of business and therefore purchasing the business is a higher than normal risk.
When designing an earnout, there are some things to keep in mind. Earnouts are one of the more common reasons for disputes after the sale. Therefore, it is a good idea to not make the earnout complicated and include, in the deal, a method to resolve disputes. Earnouts can be based on top-line revenue or some measure of profitability. Basing an earnout on top-line revenue is less likely to lead to a dispute than one based on profits.
How much of the business sale price should the earnout be? Generally, they are less than half of the sale price. However, it depends on the risk. If a business has one customer, an earnout might be a high percentage of the price.
How long a period should the earnout be based on? We typically see a one-year period. If the business sale is financed with an SBA loan, SBA requirements may not allow an earnout period longer than one year. The payment of the earnout is typically very soon after the period on which it is based ends. The payment may or may not include interest.
When there is above average business risk, an earnout can bridge the gap between what the buyer wants to pay and the seller wants to get. If the business performs, the buyer is willing to pay more and the seller receives a higher price.
Earnouts can serve a useful purpose when there is unusual or above average risk in the business being sold. And, it can be a way for a buyer and seller to reach an agreement when they are apart on the price and this is based on a difference in how they expect the business to do in the future. But, an earnout should not be used to have the buyer put normal business risk on a seller who is no longer managing the business.