Some businesses look risky to buy. Owners make promises that can't be verified, or they make projections that seem too lofty. When this happens, you can pitch an offer that will compensate the seller when—and only when—their “sure-to-happen” outlooks become a reality.
The offer that you’ll pitch is called an earnout. With it, you'll offer the seller a fair price for the business as it stands today. You'll also set metrics for the business that trigger future payouts to the seller.
When would I use an earnout?
Earnouts are common in three scenarios:
Earnouts are common in sales that take place before a key customer contract is finalized.
As a buyer, you might offer an earnout that’s contingent upon closing the contract. This ensures that you and the seller can share in the risk of it falling through or the reward of it materializing.
Earnouts may also occur when a high-risk event in the business or market is about to take place. An event could be a competitor planning to open a shop nearby or the introduction of technologies in the business’s market that may reduce the need for its products or services. Here, you and the seller may agree to share in the risk. You might agree to pay the seller a portion of sales or profits over time if the business can withstand the threat.
Earnouts are also offered when buyers and sellers disagree about the business’s past or projected performance. This may be due to poor recordkeeping practices that make assessments and forecasts difficult to complete.
Are sellers open to earnout arrangements?
Some are. Others can be persuaded to consider them. This is often the case when they learn about the tax savings this arrangement provides and the steps they can take to mitigate risks.
The earnout offers sellers willingly accept usually include four features:
- They include a promise to continue the seller's practices to help the forecasted outcomes become a reality.
- They're designed around a single metric that's easy to quantify and impossible to game.
- They offer a graduated scale of payments rather than an all-or-nothing option.
- They provide accommodation agreements that prevent the seller from being penalized in years when natural or environmental disasters prevent the business from reaching its targets.
How do I arrange an earnout?
With your attorney, you'll make an offer that includes an upfront purchase price and terms that will trigger future payouts to the seller. You might offer a set percentage of gross sales, net sales, or net profits that’ll be paid at defined intervals after the sale of the business. Or, you could offer to pay the seller a specified portion of the business’s earnings after a specific event occurs, such as the closing of an important customer contract or the attainment of a stretch sales goal.
Some buyers require the seller to continue working at the business or provide consultant services until the earnout terms are met. Others prefer to operate without the seller’s involvement. Your attorney can help you set the terms you choose and define how the seller will be compensated for any time that's contributed to the business.
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Are there standard terms for earnouts?
No. Every earnout arrangement should be tailored to the business and the factors that need to be hedged against. The metrics should make sense for the business. They should also be attainable within the timeframe you define (typically in the range of three to five years).
Some of the terms of your arrangement may include:
- A description of precisely how the earnout will be calculated
- The frequency of earnout installment payments
- The effects that certain events (including a merger or future sale of the business, changes to product offerings, or changes to the terms of the seller’s engagement in the business) may have on the earnout
- The annual or cumulative caps you'll place on earnouts
- The circumstances that may require the seller to forfeit their earnout and whether they can earn those forfeitures back
- The role the seller will play in the business and how he or she will be compensated
- The manner in which disputes will be resolved
How much should I pay upfront? How much should I hold back?
Few sellers will agree to earnouts that hold back more than 50 percent of the business’s asking price. More often, a buyer and seller will agree to an earnout that's 10 to 50 percent of the asking price.
What are the risks?
There are five risks that you should consider before you present the seller with an earnout offer:
- You and the seller may not reach an agreement on the metrics or accounting style to use to calculate payouts.
- The seller may not be willing to work for you or contribute the ways they did when they owned the business. In either case, they could cause irreparable damage to the business and limit your ability to realize the upside.
- The seller could try to game the metrics if they continue working for the business. A common example: Avoiding necessary expenditures that could help the business long term to boost its short-term profitability.
- The seller may blame you for any changes you make that keep them from attaining their earnout. These could include terminating key employees, adopting new processes, adopting or discontinuing a business line, or failing to retain a key customer.
- The earnout arrangement can inhibit your ability to sell the business before the arrangement expires. Prospective buyers may be turned off from businesses with obligations to third parties that last beyond the sale of the business.
An attorney may be able to help you mitigate some of these risks. One recommendation they might make is to appoint a third-party accountant. This person can arbitrate payout disputes and make fair, rational, and binding decisions.
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