What is An Earnout?
When making an offer to purchase a business, some buyers propose that the seller accept an earnout as a part of the transaction. An earnout is future payments made to the seller after the sale, contingent upon the business reaching future financial targets. The earnout may be extra consideration to the seller above and beyond the purchase price of the business, or it may be a promise of future consideration as a part of the purchase price. When the earnout is offered as a future ‘bonus’ or extra payment to the seller above and beyond the negotiated purchase price, then the seller has already been paid and carries little or no risk of harm if the earnout is not paid. While an earnout can bridge the valuation gap of a deal between the buyer and seller, accepting an earnout carries enormous risk for the seller and should usually be avoided.
Earnout Differs from Seller’s Note
It is crucial for business sellers to understand that an earnout is not a seller’s Note. A seller’s Note arises when the seller agrees to partially seller-finance part of the purchase price by accepting a Note from the buyer. The Note contains the contractual provisions and terms under which the Note must be paid to the seller. A seller’s Note may be secured by a UCC Lien against the assets of the business and has no contingencies as to whether or not it must be paid. A seller may execute the UCC lien and re-take the assets of the business in case of default (subject to its place in line as a lienholder). An earnout does not allow the buyer to place a lien against the assets of the business, and is not secured by the assets of the business. Further, the contingent nature of an earnout makes it highly problematic for many business owners.
Seller Not in Control of Contingencies
The major problem of an earnout is the transfer of risk from the buyer to the seller as to the performance of the business after closing. Since business valuations are based on the current state of the business, the future performance of the business beyond the control of the seller is a risk commonly taken by the buyer. Any number of economic or geopolitical events may harm the future performance of a business, but such risks are absorbed by the buyer as the new owner. More importantly, a change of ownership may also adversely affect the business after the closing through no fault of the seller. The buyer – after the closing – may institute new management policies which scare off customers or employees. If this causes the financial parameters of the earnout to not be fulfilled, then it is not fair to penalize the seller as a result.
Terms of Earnout
The provisions of an earnout may be contingent upon a wide variety of financial metrics of the business such as its future revenue, gross profit, net profit (adjusted owner benefit), or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Often, the future payments are staggered in quarterly or annual intervals over as long as 3-4 years after the closing. Some buyers may make an earnout contingent upon non-financial targets such as the percentage of customers retained at certain intervals along the length of the earnout. Sellers should be aware that after the closing, the seller must rely on the buyer to honestly disclose whether the performance targets are met. The language and definitions used in defining the provisions of an earnout in the purchase contract are also often ambiguous and subject to debate.
Example of Earnout: Sale of Beauty Salon Chain
- Gene is considering the sale of his four hair salons located throughout Palm Beach County.
- With the help of a professional business broker, Gene sets his asking price at $1.5M and receives an offer on his business from Jack.
- The offer from Jack is $750K down and a $750K earnout.
- The earnout states: “Upon the 12 month, 24 month, and 36 month anniversaries after closing, Gene shall receive payments of $250K upon each anniversary date if the business achieves $500K of annual EBITDA during the Trailing Twelve Months (TTM) as of each anniversary date.”
- Assuming Gene even wanted to entertain this offer in light of how much risk Jack is asking Gene to assume, the problematic nature of Jack self-reporting the financials of the business to Gene on a fair basis after the closing raises many potential issues.
- First, Gene would need to trust the accurate and prompt reporting of the financials on an annual basis by Jack for three years after the closing.
- Jack would be heavily incentivized for the financials to show that the EBITDA is less than $500K and for Gene to therefore not receive the earnout installment payments.
- Next, Jack may in the future choose to use his personal expenses as business expenses in his financials.
- This would be very difficult for Gene to discover, and would serve to lessen the reported EBITDA of the business.
- Lastly, Jack may in the future choose to put himself or his family members on the payroll of the business.
- By paying himself or his family this way, the reported EBITDA of the business would also go down when the owner-related salaries are deducted.
- While Jack’s owner benefit would remain the same (since owner-related salaries are ‘added back’ to owner benefit as a part of the economic profit derived by a working owner), the EBITDA deducts all payroll no matter the recipient.
- Given that half of Gene’s asking price is in the form of a tenuous earnout that is difficult to fairly enforce, Gene would be accepting an unduly high level of risk from Jack’s offer.
When offered in lieu of a significant part of the purchase price, an earnout is a very risky proposition for most business owners. Not only is the risk of unforeseen negative developments in the business after the closing transferred to the seller, but the earnout itself is often difficult to uniformly interpret and enforce.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.