What is an earnout?

An earnout is a form of consideration used when buying a company (or a portion of a company) that is contingent on the future, often financial, performance of the business. Targets are agreed before completion – if these are reached the full earnout will be payable to the seller, however often there is a tapered reduction if the performance of the company falls short of the agreed targets. This protects the purchaser if the company was purchased based on forecasts which were not achievable by the business.

We are witnessing earnouts becoming increasingly popular within the owner-managed, lower mid-market M&A space as a means of encouraging the former business owner to remain involved (and incentivised) in the business immediately following-on from its sale. An earnout is often acceptable to a seller, as it enables a ‘full’ price to be achieved based on the company reaching the pre-agreed targets.

It is payable on verification of the performance, usually annually, once the financial figures for the period have been agreed – primarily this is the year end financial statements.

What are the benefits of pursuing an earnout?

What are the benefits of pursuing an earnout? Whilst an earnout is often put forward by a potential buyer who has based their price on the forecast performance of the target company, an earnout reduces their risk of overpaying for a company where this forecast performance may not be attainable.

From the buyer’s perspective, due to the price of the business being tied to its agreed future performance, the price paid for the company up for sale is a truer reflection of its value. The process also lets the buyer defer part of the purchase price payment, allowing an increase in time for the buyer to pay, and thereby reducing the risk of a reliance on a loan. This is largely because the business itself generates the extra cash due to the seller over the earnout period.

For those selling a business, there is more chance of selling the business at its “full” value, or even an increased value if the earnout is uncapped, without having to decrease or discount the overall price from the offset. The seller can also participate and contribute to the company in terms of its future growth to help achieve the targets set.

Earnout structure

When considering an earnout structure, both the seller and the buyer need to consider:

• What is the seller’s future involvement in the business? – this should be outlined with a plan in place on how they are to detach from the business.
• What is the overall time frame? – including payment dates to the seller, taking into consideration the time in which the financial performance is to be documented.
• What are the metrics/targets on which the earnout is to be determined? – simple is usually best, based on metrics which are hard to manipulate.
• Are the targets challenging but achievable?

When considering an earnout payment, it is important to seek advice from a professional, to assist and minimise the risk of any issues arising. At PEM Corporate Finance, our team of M&A advisers are available to assist and advise on this process. Get in touch or give us a call on 01223 728222.