Earnouts are popular but complicated. In fact, people cant seem to decide if it is one word, two words or hyphenated. Lets keep it simple one word and simple is also the key to good earnouts.
An earnout is an amount that the seller of a company can earn, in addition to cash at close, by making certain post-close targets.
Earnouts can be a good way to bridge a valuation gap. For example, the buyer cannot see how he can offer more than $20mm for a company but the seller wont accept that price. The seller is convinced that the business plan moving forward is fantastic, so they agree to $20mm and (lets say) $8mm in earnout over two years, so the seller can make up to (or sometimes beyond) another $8mm if certain targets are met.
Some buyers suggest earnouts if their plan is to keep the acquired company intact and have (mostly) existing management grow the business post acquisition. Recently, buyers have been keen to buy teams and let them grow as a business unit within the new parent, but buyers have learned that once key execs of the selling company are millionaires, they (or their spouses) think something less than 60 hours a week in the office makes sense. An earnout is one way to keep their feet to the fire for a couple of years at least.
All this sounds simple when you say it fast. But earnouts can be risky. Here are a few tricks, tips and traps.
- Most importantly, get alignment. Make sure that the thing you agree to be measured against is, in fact, clearly measurable and that it aligns with the interest of the buyer and the seller. If the buyer is buying market share with the transaction, for example maybe the buyer wants the seller to migrate sellers companies to the buyers software. In this case, incenting the seller on every client converted might make sense. Sometimes sales growth is the target, sometimes EBITDA growth makes sense. Make sure the target makes business sense to the buyer and the seller.
- Both sides must agree on the plan. Once you are owned by the buyer, they control the purse strings. Maybe your earnout is tied to new sales but the new owners wont let you go to tradeshows. Make sure you have an agreed business plan AND an agreement on what happens if either side breeches. Be certain your closing documents have good strong language on this; spend time on this as it is critical.
- How long is too long? I saw a deal with a 7-year earnout. Ouch. Two to three years appears to be the most common range.
- Some large public buyers simply wont do earnouts. Companies that buy a few companies a month can soon get lost in who owes what to whom, so they wont consider an earnout. Find this out early. But even then, offering an earnout might show confidence in your growth plan and inch the price up.
- Some sellers with significant outside investors wont go for this deal. Once a deal is closed, the external investors in the selling company are completely outside the business and rely on the management team to get their share of the earnout. When external investors have control, most will take a lower selling price rather than risk an earnout.
So earnouts can be a great way for the seller to get more value, but they can also result in litigation and unhappiness. Get lots of advice on the details and it could result in a great deal. If you have specific questions, call me at 613 291 2476.