As a business owner you have spent time and money growing your company but now it is time to sell. Most sellers often think about a very common question – should I consider an earnout as part of the overall purchase price when I sell my business? There are advantages and drawbacks of considering an earnout when selling your business and unfortunately, not a straight forward yes or no answer.
First, what is an earnout? An earnout is simply a way for the buyer to pay the seller payments over a specific time period in exchange for a reduced cash down amount at closing. Earnouts can be beneficial when both parties disagree over the valuation of a business. Since a buyer’s goal is to get the best price possible for a company and the seller’s goal is to sell for the most money, an earnout is a valuable tool that allows buyer and seller to come to an agreement on a purchase price if certain sales revenues or earnings before interest, taxes, depreciation, and amortization (EBITDA) benchmarks are met.
In a perfect world, every merger and acquisition (M&A) transaction would include an earnout since the seller benefits from a higher valuation and cash payments if sales revenue grows and a buyer benefits through a reduced cash down payment with less hesitation since earnout payments are essentially paid by the revenues of the business in the future. Of course, this is the advantage of an earnout deal but not all are successful and end up paying the seller more money.
Advantages of an Earnout
An earnout can be attractive for both a seller and a buyer, but for different reasons.
For a seller, an earnout is the only way to realize the maximum valuation from a sale. If an earnout is appropriately structured and the business achieves sales revenues or EBITDA goals during that period, the total amount paid to the seller should certainly exceed any comparable all cash sale price. Earnout payments are also not taxed until they are received so the seller’s tax bill will be significantly less than an all cash sale. Often times, if a seller is confident about the growth rate of the company and the buyer is underestimating projections, that seller will be more willing to accept an earnout as part of the purchase agreement. The eagerness of a seller to have some “skin in the game” and accept the risk of an earnout also provides confidence in future performance of the business. If a buyer misses an earnout payment there are penalties and, in the end, if they default on their payments the company reverts back to the seller and the business could be sold again.
For a buyer, there are a number of reasons for an earnout structure. Most important and obvious reason is a reduced cash down payment which allows the buyer to purchase a much larger company than if only an all cash option was available. Even though the earnout should be lucrative and attractive to the seller, the buyer is able to use the future sales revenue and EBITDA of the company to pay off the agreed upon earnout terms. Earnouts also hedge the buyer’s risk if for some reason the business fails to meet financials benchmarks but at the same time, the buyer also assumes risk if the company is extremely successful. Alternatively, if the business experiences exponential growth, it may end up costing the buyer more money over the long term when compared to an outright purchase price with no earnout structure.
Drawbacks of an Earnout
While earnouts may appear and can be very attractive, earnouts may not be as lucrative for sellers as they would like them to be. Buyers need to demonstrate they are truly invested by providing a substantial cash down payment at closing. What incentive does a buyer have to continue running the business efficiently and make earnout payments if they don’t put down a large portion of the purchase price in the form of cash? An earnout is not guaranteed for a seller and thus, they need to accept the possibility and consequences of only receiving that cash down at closing.
Earnouts are most frequently tied to either sales revenue or EBITDA figures and both have their drawbacks. The seller will typically want an earnout to be associated with sales revenue figures. These numbers are usually the simplest to verify and determine earnout payments. Sellers need to understand though, buyers who are entering a new business will need time to adjust and learn how to run the company most efficiently. Depending on the industry and business, it is not uncommon for sales revenue to take a hit during the transition phase. If the earnout structure and language does not take this into consideration, the seller’s probability of receiving maximum valuation will be reduced greatly.
In addition, earnouts with EBITDA figures are regularly to the benefit of a buyer. When future earnout payments are based off EBITDA, once the business is sold the seller has no control over expenses such as administrative and marketing budget which can bloat and reduce this figure next to nothing. A buyer may have no problem with taking on large expenses that may help produce more EBITDA down the road but hurt the bottom line today, obviously at no benefit to the seller. On the other hand, if proper capital and advertising growth are not invested, both sales revenues and EBITDA will go down further reducing seller’s earnout payments.
It will always be difficult to predict if a buyer will genuinely continue to grow revenues since they don’t want to throw away their cash down payment but nonetheless, what advantage does a buyer have to met that $15MM earnout goal when it’s no sweat to sit back and follow through with $8MM? Even if a buyer is truly genuine, there is no substitute for natural disasters, a down turn economy, fraud or other uncontrollable factors that will minimize earnout payments in the future.
Earnouts can be complicated and potentially expensive, which is why it’s important to have a sell-side M&A advisor who can explain and point sellers in the right direction when considering an earnout structured purchase agreement. An experienced middle market M&A advisor understands that an earnout can be very lucrative and provide maximum value for a seller but only if structured correctly. Almost as important, the refusal or eagerness to engage in discussions regarding an earnout demonstrates to potential buyers whether or not the seller believes in the future of their company. While there is not a straightforward yes or no answer when considering an earnout, it is vital to have a trusted sell-side mergers and acquisitions firm on your team to help navigate the best options, since the difference can be a gratifying experience or depressing few years after you sell your business.
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