Earnouts (Part I): What is an Earnout? And Why is it Useful?

This post is the first in a series on the subject of earnouts.  In the world of buying and selling companies, earnouts are often used, frequently discussed, often taken for granted, and commonly misunderstood.  But before going any further on those points, let’s be clear on the basics.

1.  What is an Earnout? 

An earnout is a contractual obligation imposed on the Buyer of a business to pay the Seller additional cash after the closing of the sale if and only if the business achieves certain agreed-upon financial or non-financial targets within a specified period of time.   Put more simply, it’s a way for the Buyer to condition the payment of part of the purchase price on the post-closing performance of the business being purchased.

2.  Why is an Earnout Useful?

An earnout is useful because it helps the Buyer and Seller resolve the all-important negotiations over the purchase price and business value  – that is, on how much Buyer should pay and Seller should receive for the business.

The negotiation often goes something like this:  Seller says her business is worth $20 million, and Buyer (naturally) disagrees and argues it’s really worth $17 million.  Buyer then responds with “prove it,” and Seller says, “Fine, to get this deal done, I’ll agree to take $17 million at the closing, and then if the business achieves some agreed upon revenue (or earnings) targets within the first two years after closing, you’ll be required to pay me up to an additional $3 million.”

In the end, an earnout resolves price negotiations by providing a mechanism by which Buyer and Seller can share the risk relating to post-sale performance of the business:

• If the business does well, Seller will be entitled to a post-closing payment that will make the total sale proceeds at least as much as (and maybe more than) Seller thought it should have been at the closing.
• But if the business does poorly, Buyer will have avoided overpaying.

By allocating risk in a way the parties think is fair, an earnout can bridge the gap between Buyer’s and Seller’s competing expectations on price, and put the parties in a position to complete a deal that might otherwise have fallen apart.