When selling a business, one of the most important terms to understand is the earnout. This term refers to a payment structure where part of the sale price is paid upfront, but the remainder is contingent upon the business meeting certain performance milestones or staying on a set trajectory after the sale. This structure helps ensure that the buyer is getting a business that will continue to thrive after the transaction, and it allows the seller to benefit if the business exceeds expectations. But how exactly does an earnout work, and why might it be an attractive option for both parties involved?
What Does An Earnout Mean?
An earnout is a financial arrangement commonly included in the sale of a business. When selling your business, you may receive an initial lump sum payment at the time of the sale. However, the rest of the sale price may be tied to specific future milestones that are agreed upon between you (the seller) and the buyer. These milestones can be based on a variety of factors, such as business revenue, profit margins, customer retention, or even operational metrics.
For instance, if your business reaches a pre-defined revenue target over the next few years, you'll receive additional payments (the "earnout"). The goal of an earnout is to bridge the gap between the buyer’s and seller's expectations, especially when there is uncertainty about the business's future performance after the sale.
How Does An Earnout Work?
The earnout structure can vary significantly depending on the negotiation between the buyer and seller, but it typically works like this:
Upfront Payment: At closing, the seller receives an initial lump sum payment, which could range from a small percentage to a substantial portion of the total purchase price. This amount might be determined based on the business's valuation at the time of sale.
Earnout Period: The remaining amount of the sale price is tied to certain business performance goals. These can be set over a period of one to five years, depending on what both parties agree upon.
Milestones: The performance goals can include revenue targets, profit margins, or other measurable metrics, like customer retention or market share growth. If the business meets these goals, the seller will earn additional payments, which are typically made annually or quarterly.
Payment Structure: The amount of the earnout can be structured as a fixed amount or a percentage of the performance metric. The seller may receive these payments in installments over the earnout period.
Example Of An Earnout
Let’s say you are selling your business for $10 million. The buyer agrees to pay you $6 million upfront, with the remaining $4 million contingent on the business meeting certain revenue targets over the next three years.
Upfront Payment: $6 million
Earnout Payments:
Year 1: $1 million if the business hits $5 million in revenue.
Year 2: $1.5 million if the business maintains at least $5.5 million in revenue.
Year 3: $1.5 million if the business reaches $6 million in revenue.
In this example, you could potentially earn an additional $4 million if the business hits the agreed-upon revenue targets. However, if the business doesn’t perform as expected and fails to meet the revenue thresholds, you might receive little to no earnout payment.
Why Include An Earnout?
For Sellers: An earnout can be an appealing option because it allows you to secure a higher total sale price based on the future success of the business. If you are confident that your business will continue to thrive under the new ownership, an earnout provides a way to benefit from that future growth.
For Buyers: On the flip side, an earnout helps buyers minimize the risk of paying too much for a business that might underperform after the sale. It ensures that the seller has some "skin in the game" and remains motivated to help the business succeed post-sale.
Both parties have a shared incentive to ensure the business succeeds, which can lead to a more positive post-sale experience.
Considerations And Risks
While earnouts offer flexibility and the potential for higher overall payouts, they come with risks. The most significant risks for sellers include:
Uncertainty: There’s always a chance that the business may not meet the agreed-upon milestones, leading to lower earnout payments or none at all.
Control: Sellers may be required to remain involved with the business for a period of time after the sale. This could include staying on in a leadership role or helping with the transition. If the seller doesn't want to stay involved post-sale, it could complicate the deal.
Disagreements: Earnouts can sometimes lead to disputes about whether the business achieved the milestones set out in the agreement. Having clear, well-defined terms can help prevent these disagreements.
Working With Experts
If you’re considering selling your business and exploring the possibility of an earnout arrangement, it’s crucial to work with professionals who understand the complexities of these deals. Exit Stage Left Advisors (visit esladvisors.com) specializes in helping business owners navigate the process of selling their companies, including structuring earnouts that protect both the buyer and seller. With expert guidance, you can ensure that your sale goes smoothly and that you’re able to maximize your payout.
Conclusion
An earnout can be a powerful tool when selling your business, allowing you to receive more than just an upfront lump sum. It’s a win-win for both the seller and the buyer if the business performs well after the transaction, but it’s important to carefully consider the terms and structure of the earnout to ensure it aligns with your goals. Whether you’re looking to stay involved in the business or simply want to secure the best possible deal, an earnout could be the solution you're looking for.
