Structuring Earnouts

Steps to Selling your Business Part 33.

One of the critical components of this last stretch in selling your business centers around structuring how the purchase price will be paid. This post will cover a common and crucial component of many Letters of Intent—the Earnout.

Most business sales must deal with the differences between how a buyer and seller see the future and the uncertainty of future events. When both parties agree that the future appears certain, the purchase price will usually be paid in cash at closing.

However, in today’s environment, we all live with great uncertainty. Consider some situations where at closing, it is impossible to know for sure what will happen over the next 12 to 24 months. A new product has just been launched – how will it perform? A significant proposal has come in – will it be won? A critical supplier is reviewing who it will deal with – will the relationship survive? There has been a significant recent change in earnings – what is the new steady-state?

The most common way buyers and sellers deal with these are to share the risks and the rewards of the outcomes. We think of this sharing as risk apportionment. Future payouts are classified as contingent considerations in transactions and are typically called an earnout.

An earnout is a future payout, dependent on achieving stipulated performance targets.

An example: In the month before closing, a business signed a new large customer. These new sales could significantly increase profitability if that customer is able to grow as well as they think. Without the new customer, the business value is $40 million, but with the new customer and the best-case results, the business value is $50 million. The buyer and seller could agree to a transaction structure of $40 million cash at closing and a $10 million earnout paid in 12 months if the new customer performs as hoped.

One common concern with earnouts is that you tie some of your payout to a company’s performance that you no longer control. Earnouts can be risky – they give the buyer great influence over the money you stand to earn.

An earnout is frequently used because it provides the buyer with a sense of protection while your company proves itself in real-time.

The key to a well-structured earnout is to closely tie the mechanism to the actual risk. Your advisor should have a thorough understanding of the risk and the economics of all the “what ifs.”

While building an earnout, a good team of Advisors will remember their mission and stick to it as they negotiate to get the best / lowest risk transaction structure for their seller client that works for the buyer too. If the deal doesn’t work for everyone, it works for no one.

We use earnouts to bridge valuation gaps between buyers and sellers that are caused by different perspectives on the future.

In my experience, buyers most often want these performance markers tied to easy, big-picture metrics like EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization). This seems like a sensible and natural marker to set, but they are not our preferred approach.

Why is that? Simply this – we want the buyer to have the freedom to structure SG&A (Selling, General, and Administrative) expenses, supporting functions, marketing, etc., in any way they want that is good for the long-term health and growth of the business. However, we don’t want our seller clients to pay the price for these changes because they have reduced EBITDA in the earnout period.

Post-closing buyer changes can have short-term negative consequences for profitability and earnouts if you have attached your earnout to profitability metrics.

To mitigate against this, we negotiate two things in the structure of our client’s earnout:

1. SHORT TIMELINES Depending on the underlying reason for the earnout, we negotiate short timeframes for the earnout – usually 12 to 24 months. An extended timeline leaves undue risk on your shoulders.

2. THE RIGHT BENCHMARKS— I refer to this as moving your payouts up the income statement. Metrics such as gross margins and total revenues are better suited to protect your valuation and eliminate areas of dispute than EBITDA measures. We also look for other creative performance metrics for earnouts based on the underlying risks. Customer retention, for example, could be used as a one-time marker.

If your Advisors can get these terms balanced precisely, it will feel like a win for both sides when the final deal is inked, and that is what we are looking for. The only sure way I have found to get there is through sheer diligence and dedication to the process from the very beginning.

In our next post, I will discuss where diligence and dedication pay off the most: minimizing the consequences of your risk analysis on the final value of your company.

If you are planning to divest your business or have questions for one of our Advisors, please contact our team today.

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Written by: Douglas Nix