13 Dec Should You Consider an Earnout When Selling Your Company?
Earnouts can be used to help buyers and sellers overcome obstacles presented when both parties value a business differently. If the seller is asking more than a buyer is willing to pay, an earnout may be used to save the deal. An earnout allows the seller to receive payments over a specified time period if the business achieves certain goals. Typically, these goals are financial and include meeting specific EBITDA or revenue targets.
Should You Consider An Earnout?
In theory, earnouts sound great. They allow buyers and sellers to bridge the valuation gap and get to a close. Earnouts allow the seller to benefit after the deal is done if the metrics are met. Buyers benefit from reduced uncertainty since payment is tied to future performance. However, not everything that sounds good in theory works well in the real world.
Earnouts typically don’t pay out as the sellers hope they would. This underscores the need to make sure you are completely satisfied with the consideration paid at close. A wise man once told me that sellers should push for as much cash at close as possible, since an earnout that sounds good during negotiations may ultimately never pay out.
Some reasons that earnouts don’t pay out as planned include:
- Poor attention to detail when writing the agreement;
- The business grows at a slower rate post-sale;
- The buyer isn’t motivated to hit financial targets that would trigger a payment to the seller
Details, Details, Details
When drafting the language for an earnout it is not possible to pay too much attention to detail. As they say, the devil is in the details. The language used can benefit either the buyer or seller. For example, if future payments are tied to EBITDA this benefits the buyer. Once the company is sold, corporate expenses could be pushed down to a divisional level that ultimately hurts EBITDA. Alternatively, payments tied to future revenue typically favor sellers as revenue tends to be a rather clean figure.
However, sellers should still be wary of earnouts tied to revenue figures. It isn’t uncommon for revenues to dip following a transaction. This is due to the fact that the new owners are trying to learn about the business while keeping it running. If the learning curve is particularly steep, revenues could suffer for an extended period of time. This will hurt a seller’s chance of maximizing their earnout.
Revenue can also be curtailed if the new owner doesn’t commit capital to marketing and business development. If the seller expects the buyer to start, or continue, an aggressive marketing campaign they may be in for a rude awakening. A buyer may be more than happy to reduce the marketing budget for a year if that means the seller will not hit the targets to trigger an earnout. If the buyer is able to pay $10M for a business, as opposed to $20M that includes earnout payments, don’t expect them to engage in a strong promotional campaign to help you.
Sellers need to consider a variety of factors prior to agreeing to an earnout. Various events can occur during the earnout period that reduce, or eliminate, the payments a seller expected to receive.
One such scenario is when a company is sold to an even larger company. After the sale you cannot expect decisions to be made in the same manner as when you were running the show. Larger corporations are notorious for slower decision making and “red tape”. The slower decision making and new procedures to implement a decision may greatly increase the time it takes to effect a change. This slowdown could jeopardize your ability to maximize your earnout.
Another scenario to consider is the buyer taking on additional expenses during the earnout period. Expenses that hurt EBITDA today, but are expected to produce value in the future, may benefit the buyer. The seller may not be as fortunate. If expenses are incurred today to generate revenues in the future, the buyer will benefit. The seller will not.
Finally, it is important to consider the various unexpected events that may take place during your earnout. A hit to the economy, a natural disaster, fraud within the company, and a variety of other possibilities should be taking into consideration. It is impossible to plan for every adverse scenario, but a diligent seller will spend some time thinking about what could happen to the company, how it will impact their earnout, and how they can work with the buyer to mitigate the risk.
Considerations When Structuring an Earnout
Earnouts can be a double-edged sword. They are common in many deals and can be structured to benefit the buyer or seller. If you plan to use an earnout when selling your business, consider the following:
- What will the business look like post-sale if growth slows? Will you still consider the deal to be worthwhile?
- If your earnout is tied to revenue, ask the buyer to commit to full sales & marketing support on day 1. Be sure this doesn’t impact your earnout calculation.
- Ensure the earnout and payment calculations are crystal clear. Any ambiguity could be used against you.
Sellers should also understand that their willingness, or lake thereof, to consider an earnout can be a signal to a potential buyer. Sellers that adamantly refuse to consider an earnout are signaling that they do not have faith in the future prospects of the business. Certain buyers may view this as a red flag and proceed with caution or abandon discussions entirely.
It’s impossible to say that earnouts are “always good” or “always bad”. The deal, the parties involved, and the seller’s needs will all play a role in determining if an earnout is truly a viable option. When it comes time to sell your business, engaging a sell side advisor to help you navigate the payout structure may be just what you need. A team that is always in your corner and has experience in deal structuring can be the difference between a rewarding sale of your company or a disappointing experience.