How soon, and by how much, should you agree to an earnout arrangement when selling? By TOM McKASKILL.
By Tom McKaskill
Earnouts are arrangements in which sellers of a business receive additional future payment, usually based on future earnings. Where are these arrangements beneficial?
Earnouts are normally used to overcome the gap between what the vendor thinks the business is worth due to its future potential and what the buyer feels is a reasonable price for the future earnings they can reasonably expect.
Sometimes it is simply optimism on the part of the vendor, but there are often situations where the buyer is willing to pay more if future events or outcomes validate the vendor’s projections. Working out the basis of such an earnout is, however, very problematic.
An earnout is often settled upon where the vendor is not prepared to sell at the firm price offered by the buyer, and the buyer is unwilling to walk away from the deal. The buyer will argue that just because the vendor thinks the business will generate higher profits in the future is not sufficient in itself to justify a higher acquisition price. The vendor, on the other hand, will try to show why the higher future earnings can be expected to materialise.
In order to conclude a deal, both parties agree that the buyer will pay an additional amount based on some agreed schedule of events occurring and/or on the basis of some agreed achievement of revenue, earnings or performance. The work involved in meeting agreed targets can be performed by the vendor alone, by both parties, by the buyer alone or even by an external party.
Earnouts are most often based on earnings, or some combination of revenue, gross or net margins and budget. The difficulty experienced in meeting earnout conditions are numerous. The buyer may hinder the vendor by limiting resources, by interfering, by changing strategy or failing to provide adequate support. The vendor my manipulate expenses, revenue and resources to achieve the targets, and in doing so breach the agreement or disrupt the future of the business.
External events may hinder progress, or the vendor may be incapacitated in some way from putting in the effort required. Concentration on the earnout over an extended period may frustrate the buyer from achieving progress in a situation where business conditions have changed, but the earnout conditions are not able to reflect changing priorities.
The most workable earnout agreements are those where neither the vendor nor the buyer have a significant effect over the outcome of a target event. Where items in progress are destined for final decisions, such as a large contract, grant of rights or a license, these may be determined without much intervention by either party but may have a significant effect on the future potential of the business.
In such circumstances both parties may be willing to agree on an additional sale value component to the vendor. Where significant effort is required by either or both parties to achieve the performance or event targets, the earnout is likely to end in dispute or be renegotiated due to unforeseen circumstances.
Where possible the vendor should try to avoid an earnout situation or at least put it on a basis where the buyer has little influence and where the outcomes are not subject to interpretation.
Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia.