In the world of transactions, there is lots of “fun” jargon to digest. Buying or selling businesses is referred to as Mergers and Acquisitions, M&A for short. The abbreviation M&A is only the tip of the word soup iceberg though. Q of E (Quality of Earnings), EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), the multiple (how many times the earnings a Buyer is willing to pay you for your business), and a Seller carry (the Seller holding a note for some of the purchase price) are just a few of the terms you will hear bandied about.
If you intend to sell your business at some point, you need to know what these terms mean and the concepts behind them. Another term you will encounter, which is what we will discuss this month, is an “Earnout.”
Earnouts are everywhere in M&A. Essentially, an Earnout is a kind of bonus or contingent part of your purchase price should the business hit a specific milestone in a certain time frame after the new Buyer takes over. An Earnout is often used to (at least in the Buyer’s mind) reasonably bridge the gap between what the Seller wants for the business and what the Buyer is ultimately willing to pay.
In most cases, Earnouts are tied to specific financial metrics. They can also be non-monetary like winning a big contract that is “in process” but not quite complete by the time the deal closes.
Buyers appreciate Earnouts because they are typically “stretch goals,” low risk, keep the purchase price in line, and incent the old owner to work for the greater good. Sellers typically don’t like Earnouts because, well, they want the cash in hand.
If you are selling your business and are offered an Earnout, remember the following:
1. Participate actively in the Earnout negotiation. Stretch goals are good. Pie in the sky is a waste of time.
2. What is the “term,” or time frame?
3. How will the payments be structured? Annually, quarterly, etc.
4. Compare apples to apples – meaning if the Buyer (particularly Private Equity) is involved in the Earnout, make sure you understand how they intend to run the financials after close. If you aren’t doing GAAP accounting now (which most Sellers don’t use), you may be in for a shock on the calculation.
In the last couple of years, I have been involved in transactions with some complicated Earnouts, and I’ve had a few unfortunately devolve into threatened litigation. Therefore, I prefer Earnouts to be transparent, easy to understand, and with some kind of minimum and maximum component. In other words, the Seller will gain something even if the business doesn’t hit the stretch goal.
Contrary to its name, the most important thing to know about an Earnout is they are hardly ever actually earned, so understand that the cash part of your purchase price is the only thing you will likely pocket. An Earnout should be the gravy on top, not the meatloaf itself.
