The value of a privately held business often includes a measure of subjectivity, meaning it will probably be different depending on who you ask. The buyer has one idea what the purchase price ought to be. The seller may have another.
Part of the reason this happens is due to how valuations are done. A privately held business is often valued by looking at past performance to help predict future profitability. The past does not fairly represent the future in all cases and might not be accurate, depending on the industry or specific characteristics of the company. Imagine a seller who recently invested in new equipment or signed a big new contract. They have reason to believe the company’s future is brighter than its historical performance, and may want to share in the future benefits flowing from their investment of time and resources. From the buyer’s perspective, however, neither new equipment nor new customers are any guarantee of higher profits. In fact, these new factors introduce risk because the buyer is going to be the one responsible for executing on the new equipment or client once the sale is complete. The buyer may not agree with the seller’s forecast for the industry, the business or even the overall economy, or they may be concerned about losing customers once the sale is complete, especially if the current owner has close, personal relationships with their customers.
Suffice it to say, there are often differences of opinion between the buyer and the seller. One option to bridge this difference is an earnout. Earnouts are contingency payments made from the buyer to the seller after the sale of the business which are dependent upon the future performance of the company. In other words, the seller receives payments if the business performs to a certain level. If it doesn’t, no matter the reason, you will not see those payments.
Earnouts can give the buyer confidence that the seller will work to make the transaction successful after the sale and can bridge the difference between what each party considers a fair purchase price. Be cautious with earnouts and very careful in how you decide upon and structure them.
Considerations for Earnouts
Earnouts can be structured in a variety of ways, but are always tied to future performance, whether that’s revenue, gross profit or net profit. They can also be tied to a specific event, such as a key employee, customer or contract remaining in place for a defined period of time after the sale. Earnouts can be based on growth or maintaining a certain level of performance for a set period of time.
The keys to a well-structured earnout include:
- Setting well-defined parameters in the purchase and sale agreement. Vague earnouts can lead to lawsuits down the road if calculation methodologies and definitions are not agreed to early on. You and the buyer may understand each other, but be sure to put the exact terms in writing so there is no room for misunderstanding or disagreement.
- Defining a dispute resolution process. In case disagreement does arise down the road, a process you both agreed to prior to the sale can save considerable cost in time, stress and resources.
- Placing the measurement of the earnout in its proper place on the income statement. The further down the measurement for the earnout, the greater the chances for disagreement over the result. If net income is used to determine the earnout, the seller will be motivated by short-term profits while the buyer may be focused on investing for longer term benefits, like hiring more staff or investing in infrastructure.
While using net income to determine the amount of the earnout can lead to contention based on long vs. short-term goals, using revenue can also lead to disagreements because the seller, if still involved in the business, may be motivated by revenue growth regardless of profitability. A good compromise is to use gross profit as a measure of profitability. This will incentivize growth as long as it’s profitable and eliminate potential arguments over general and administrative expenses.
An earnout is, in a sense, a gamble on the future performance of the company. While you may be confident of your company, your employees and your buyer, keep in mind that you will have little to no control after the sale. Consider very carefully what portion of the purchase price you want dependent on how the company performs under the new owner. It’s entirely possible you will never see a dime of the earnouts you were confident about.
Again, make absolutely sure there is a dispute resolution process in place before signing on the dotted line.
Earnouts can be a useful way to bridge the gap in disagreement over purchase price, but they’re not perfect. In fact, they are a last resort. As the seller, make sure your financial goals are met without the earnout and consider the earnout an added bonus.
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