Many business exits require the seller to stay involved after completion through an arrangement known as an earnout.
Under an earnout, the buyer pays part of the purchase price upfront. The balance is paid over time if the business meets agreed performance targets.
Earnouts can work well, but they often create tension. Sellers worry that if performance dips, or if the buyer changes how the business is managed, they may never receive the full price.
When used in the right context, earnouts can share risk and help secure a deal. They keep the seller involved and motivated after the sale. This helps maintain performance and ensures the buyer receives the value they paid for.
For an earnout to work, both parties must understand it clearly. It also needs to be structured in a way that feels fair and workable for both sides. So, how does this operate in practice?
Why consider an earnout?
Buyers often request earnouts to make sure the value in the business genuinely transfers at sale. They tie the seller to the business for a defined period sometimes up to five years so the business continues operating at the same level of performance.
Buyers also use earnouts to allow enough time for the seller to transfer key knowledge, relationships and operational expertise.
During negotiations, parties typically frame an earnout as a risk-sharing mechanism. Buyers use it to manage concerns about future performance. Sellers use it to justify a higher sale price when they are willing to share some of that risk.
Risks relating to earnout arrangements
There are also potential risks for using a deal structure that involves using earnouts.
Earnouts are often contingent on the founders staying on board with the business to lead it and transition it for a substantial period. The risk here is that founders can butt heads with the new owners on how best to run the business, and generally having a hard time adjusting to the new world order in which they have moved from being the one calling the shots to being an employee.
This loss of control is a common but often unacknowledged factor that contributes to post acquisition failure. But there are also many other potential thorns along the way – including the way in which the earn out is calculated and appropriate controls over how the buyer runs the business during the earn out period.
The best way to deal with the issues associated with earnouts is a solid approach and solid contract!
Structuring earnouts
Proportion: The first consideration is what proportion of the purchase price will be paid at completion (the point of sale) versus the amount calculated based on the earnout period.
Earnouts will typically form an increased proportion of the total sale price where:
- a business valuation is based on future potential;
- there are risks in the buyer being able to fully transfer or sustain the value of the business.
Deals where the value is clearly related to sustained performance of the business (i.e. it is mature) and/or where that performance is likely to continue (i.e. income and profit is relatively stable) are less likely to have a significant earnout.
Calculation: The parties can structure the earnout as a fixed sum or on a sliding scale.
With a fixed-sum earnout, the full amount becomes payable if the business meets the agreed target. If it does not meet the target, the buyer pays nothing. This approach means the seller shares the risk that the business may not achieve the agreed revenue or profit after completion.
Under a sliding scale, the buyer calculates the seller’s payment as a percentage of revenue or profit over defined periods. In many cases, once the business reaches a minimum target, the buyer calculates the earnout by reference to actual performance above that threshold.
Earnouts based on revenue rather than profit can be easier to manage. However, earnouts in larger deals are regularly based on the latter.
Controls: There needs to be a balance between protecting the seller and impacting the buyer’s ability to operate the business the way they want. You will need to consider what operational controls will be relevant for you and be clear on these when you structure the earn out. For example, who will run the business? Will you follow a business plan? Will the buyer be restricted in how it deals with the assets in the business, or in the way in which it invests into the business?
The parties can build in financial controls to protect performance. For example, the agreement may require the buyer to maintain adequate working capital. It can also require funding for key resources and retention of specific assets. These measures help the business achieve its projected results.
It is equally important to agree upfront on how the earnout accounts will operate. The parties should clearly define how the accounts will be prepared. They should also specify which expenses will be included or excluded from the calculation.
Sellers should consider restricting the buyer from diverting clients. They may also prevent the buyer from trading outside the business in ways that could undermine earnout performance.
If you structure your deal with an earnout, clarity is essential. Both sides must understand the terms. The contracts should be strong enough to protect future payments while balancing control. An experienced deal team can help manage this process. Their guidance reduces risk and helps keep the transaction on track.
Joanna Oakey, author of Buy Grow Exit, is the founder and Managing Partner of commercial law firm, Aspect Legal and host of the successful business podcasts Talking Law & The Deal Room. She brings decades of experience-based insights from working with business owners (and their advisors) on acquisitions, exits and general commercial legal matters. Order your copy today at https://bit.ly/99c-ebook.
