What is an Earnout and How Do They Work: Pros and Cons

September 19, 2023

Seller enjoying the success from an earnout strategy

At a Glance

Main Takeaway

An earnout is a type of mergers and acquisitions (M&A) strategy used when initial negotiations do not go as planned with an outright offer. Business owners typically use it as an alternative sales agreement during the M&A process when there is disagreement on the organization’s value.

Rather than receive a lump sum for the sale of the company, the parties may enter into an earnout arrangement, in which the seller receives payments from the buyer as the business performs well and meets pre-defined objectives specified in the agreement.

Next Step

Understanding how an earnout strategy works and its potential benefits and drawbacks can help you determine whether it is the right solution when selling your business.

How Earnouts Work

An owner’s view of their business’s value may differ from the acquirer’s. Even if a buyer is interested in acquiring a business, they may not be willing or able to pay the asking price upfront in cash for the entire business.

If negotiations do not result in a purchase price with clear terms the seller and buyer are satisfied with, an earnout strategy can be proposed to address the valuation or monetary gap.

With this mergers and acquisitions strategy, the owner sells the business for a lower upfront value than initially planned. In exchange, the buyer signs an agreement to send the seller future payments if the company performs well or as intended in the agreement. These payments, known as earnouts, allow the buyer to make up the difference between the negotiated sale price and the seller’s desired price.

When negotiating an earnout strategy, the seller and buyer must agree on the performance targets the business must achieve to trigger earnout payments. The seller will also outline how long the earnout period lasts, after which the acquirer will retain all profits of their newly purchased business.

Types of Performance Metrics in Earnout Strategies

Various performance metrics define the financial objectives of your earnout strategy. Depending on the agreements between the seller and buyer, you may use the following:

Revenue targets. The most common way to gauge a business’s financial performance is to measure its revenue over set periods, such as monthly or annual revenue. The seller may receive earnout payments if the company meets the negotiated “top line” targets after the buyer enters the agreement.

Profitability metrics. Another typical performance target used in earnout negotiations is profitability. It is typically measured using net profit margins or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). These metrics may be preferable if you want to measure the business’s performance based on its “bottom line” instead of pure revenues.

Product development and launches. If your business’s success depends on developing and launching products or services, you may define your earnout targets based on the number or financial performance of successful launches.

This metric is commonly used in the automotive, consumer electronics, gaming, and entertainment industries. It can also be a good choice if your business is an innovation-driven startup about to launch a new product, as it allows you to benefit from the product’s success even after selling it. This strategy works if the seller peels that business into a separate structure, allowing another company to purchase that brand or product.

Customer-based metrics. You can define earnout targets around customer metrics if the business is in the service industry or measures success based on customer sales and interactions. These include customer acquisition, retention numbers, and average lifetime value.

Other defined milestones. The seller and buyer may design unique milestones, targets, and achievements for the earnout strategy. For example, an earnout strategy can be centered around regulatory compliance, achieving specific certifications, or obtaining audit levels that validate performance.

If the business is in the technology sector, achieving information security certifications such as SOC 2 or ISO 27001 can be used as milestones for an earnout plan.

Potential Benefits of an Earnout Strategy

Entering an earnout strategy with a buyer can provide multiple potential benefits for both parties, especially if the business performs well after the sale. The most significant advantages of an earnout agreement include:

Bridging the valuation gap. Earnout strategies are an efficient solution if there is a gap between the seller’s estimation of the business’s value and the amount the buyer is willing to pay. It allows the parties to close a deal and complete a sale that may have initially stalled or fallen through.

Both parties have a vested interest. Entering an earnout strategy with the buyer also ensures both parties retain a vested interest in the business’s performance since your earnout payments are tied to meeting performance objectives in the agreement.

It can be a better deal than a direct sale. If the buyer meets all defined objectives and completes the earnout period successfully, the payments the seller receives can compensate for the valuation gap. The combined sale price and earnout payments can exceed your initial sale price if the business is highly successful.

This outcome benefits both parties, as the buyer inherits a thriving business, and the seller receives more than planned in the initial stages of negotiations.

Can retain key employees. Depending on the specifics of your negotiations with the buyer, an earnout strategy can also benefit your employees. For instance, if you consider specific team members crucial to your business’s success, an earnout strategy can include clauses to ensure their continued employment or arrange for them to receive earnout payments.

Potential Drawbacks to Consider

Earnout strategies are a risk vs. reward solution. The more uncertainty around the business’s performance, the more risk both parties take. There are potential drawbacks to choosing an earnout plan, which includes:

Earnout payments are delayed. Unlike a direct sale for an upfront cost, where the seller receives a single lump sum, earnout payments are provided over a negotiated period. Even if the business is successful, the seller might not receive their initial estimate until months, possibly years, after the sale. The seller must consider their financial situation and needs before entering into an earnout strategy.

Payments depend on success. If the business fails to meet the established performance targets, the seller may not receive the earnout payments negotiated with the buyer. An earnout strategy may not be the right solution if performance-related reasons are why the owner wishes to sell the business.

A limited degree of involvement. Entering an earnout strategy means the seller has only the level of involvement negotiated in the agreement. The business’s performance or the seller’s ability to influence business operations during the earnout period depends almost entirely on the buyer. If the buyer sees the seller as a threat to the business’s operations, the seller may lose control over how much they can influence the earnout.

An earnout plan may be unsuitable if the seller is not confident in the buyer’s ability to effectively manage the business or integrate it into their existing operations.

Develop a Beneficial Earnout Plan with Windes

If you plan to sell your business, finding the right buyer and negotiating favorable terms is critical to meet your financial objectives. Windes’ Mergers & Acquisitions team can advise you on various M&A strategies, including a potential earnout arrangement.

We will guide you through all aspects of your M&A, ensuring your deal is beneficially structured, whether buying or selling. We offer a range of services to help make the transition and earnout period as smooth as possible, from helping you draft a letter of intent to modeling your cash flow and analyzing the quality of your earnings and EBITDA.