Earnouts Explained: A Tool To Maximising Your Business Sale Price
WHAT IS AN EARNOUT?
An earnout is essentially a portion of the business sale price which is contingent (and deferred) on the business achieving certain milestones during a specified time period, after settlement. The portion of the sale price retained by the earnout may be as low as 10% or as high at 35%.
It is important to note that an earnout is not a purchase price adjustment. The contingent purchase price (or earnout) is payable to the seller by the buyer once the milestone has been achieved.
WHEN SHOULD YOU CONSIDER USING AN EARNOUT?
Without a doubt, the most common reason an earnout is used is when the buyer and the seller can’t agree on the sale price. An earnout is a useful financial tool used to bridge the valuation gap between what a buyer is prepared to pay for a business, and what a seller is prepared to sell for. In these scenarios, without an earnout the business sale would not proceed.
KEY ADVANTAGES FOR USING AN EARNOUT
1) The seller wants to exit and the sale and purchase transaction will occur as the buyer and the seller agree on the headline price
2) The seller can maximise the value received for their business
3) The buyer has a higher chance of completion as the funds required to settle will be reduced by the value of the earnout
4) It creates a closer working relationship and more favourable outcome between each party with maximum knowledge transfer between the seller and the buyer due to a material and financial consideration to be paid in the future
5) It can be used as a form of incentive based employment remuneration to keep the seller involved with the business as an employee after settlement
KEY DISADVANTAGES FOR USING AN EARNOUT
1) The seller will have to relinquish control of the business to the buyer at settlement. The earnout portion of the sale price will still be at risk when ownership has changed hands from the seller to the buyer
2) The seller may not have sufficient control to maximise their earnout
3) Short term and long term goals may be clouded (depending on how the earnout is structured)
4) A poorly structured earnout can result in litigation between the seller and the buyer. This can occur where either party feels their interests have not been maximised during the specified time period to which the earnout is based
In the SME market (businesses with sale values of $1 Million to $70 Million), earnouts are usually based on the business achieving one of the following milestones:
2) Gross Profit (“GP”)
3) Earnings before interest, tax, depreciation and amortisation (“EBITDA”). EBITDA is essentially the business profit before financing costs, depreciation and tax
Depending on the type of business, in our experience sellers usually prefer revenue and buyers prefer GP. For sellers, revenue is harder to manipulate and is most likely the easiest of the three items the seller can control after settlement.
Buyers like GP as this ensures the seller maintains margin control and is not focused on maximising sales by reduced margins or loss leading sales.
Although challenging, a good advisor should be in a position to negotiate an appropriate measure for each party based on their individual needs.