by Dave Driscoll
Consider this paradigm: A seller most always believes his/her business is worth more than a buyer is willing to pay.
An earnout is a good strategy to maximize seller expectations regarding total selling price, especially when the seller is confident in the future sales of the company and the buyer’s management ability but the buyer is reluctant to pay top dollar on future unknown variables.
Earnouts are contractual contingent payments in which the purchase price is stated in terms of a minimum but the seller is entitled to additional compensation if the business reaches certain financial benchmarks in the future. The payments can be calculated on sales, gross profit, net profit or other benchmarks but are most often based on sales (not profits) and tied to increasing revenue over historical levels.
After experiencing the economic calamity of 2008-09, many owners are hesitant to list their business for sale today because of their confidence that business will improve to previous performance in the near future. However, waiting may also create anxiety to sell because of age, burnout, and the desire to spend time with family or pursuing personal interests. Earnouts commonly establish a floor or ceiling; in an improving economy, a seller can use an earnout provision to obtain a value closer to what would have been commanded in an improved economy.
An earnout provision is good for both the seller and the buyer. The seller receives payments based on future business performance and is in a better position to obtain a value that matches or exceeds expectations. An earnout may enable the business to be sold in the current market rather than enduring the uncertainty of the future and trying to time the sale of your business to the best possible market. (Never a good idea!)
Buyers like earnouts because they are protected against overpaying for the business if it doesn’t meet the seller’s growth projections. Another buyer benefit is that the seller has a vested interest in the continued success of the business.
Successful earnouts are achieved when the agreement is limited to one or two variables within a solid three- to five-year sales forecast accompanied by a seller employment/consulting agreement that ensures that appropriate steps are being taken to reach the defined goals. Finally, the contract must specify the person or firm chosen by the seller to be responsible for managing or reviewing the books and verifying the business performance
Earnouts enable owners to remove uncertainty today and secure a buyer for their business while addressing the value gap between seller expectation and buyer willingness to pay. When you sell your business, this may provide the best option for achieving your objectives to finance your “Life Beyond Business.”
Dave Driscoll is president of Metro Business Advisors, a mergers and acquisitions business broker, business valuation, and exit/succession planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.
Submitted 7 years 280 days ago