What Is an Earnout?

How an Earnout Works

In an earnout, the buyer of the business agrees to pay the seller a fixed multiple of the profits of the business in the next few years. The principle is that the better the company performs in the future, the faster the seller-financed loan is paid off.

There are several ways to calculate an earn-out. In most cases, the business or the business assets are valued during the negotiation process, and a lump sum payout is determined. The payouts are spread out over several years and are tied to the profits of the business, so if profits are high, the payouts are made more quickly.

If profits are not as high, the payouts are lower and the loan takes longer to be paid off. The earnout agreement usually includes a minimum payment amount for each year and a common term for these agreements is one to three years, with some going as long as five years. 

For example, if a buyer and seller agree on the purchase price of a business as $750,000, the seller may agree to be paid back this price over five years, based on a percentage of the net profits of the business, with a minimum payment of $150,000 each year.

The seller may establish a minimum earnings percentage or fixed amount for each year. In the first year, the minimum might be 10% of net earnings before interest, taxes, depreciation, and amortization (EBITDA), and no less than $150,000. In the second year, the minimum might be $200,000, and so forth, until the agreed-upon total amount is reached.  

Earnouts are useful in certain situations: 

• When the business has a limited operating history but has significant growth potential
• Under an uncertain economic climate or in a volatile industry, like the energy and technology industries
• With a business that has had a hard time in the past meeting its projections
• With a product that’s gone unproven or is trying to break ground in a new market

What To Include in an Earnout Agreement

An earnout is a contract, and all terms and definitions must be exact. In particular, the terms earnings, profits, and net income might differ, so the basis for the calculation should be clear to both parties. For example, the earnout targets could be based on revenue growth, gross profit, or EBITDA.

Pros and Cons of Earnouts

Pros Explained

• Part of the buyer's payment is spread out: From the buyer's point of view, the financing is spread out over a period of years, which makes it easier to pay for the business sale.
• Lower payments in years of lower profits: Since the payback is tied to profits, the buyer doesn't have to pay as much if profits are not high. 
• Spreads out capital gains tax impact on seller: From the seller's point of view, the ability to spread out payments through several tax years helps reduce the capital gains tax impact.
• Buyer has an incentive to do well: In situations where the buyer runs the company, the buyer has an incentive to do well in order to pay off the seller's financing as soon as possible.

Drawbacks Explained

• Seller may want to intrude into business operations: From the buyer's point of view, the seller is still tied to the business and may want to step in and "help out" if earnings are not high. If the seller's leadership is what caused poor performance in the past, their involvement may hinder the company.
• Profits may not be high enough to meet minimum requirements: Depending on the terms of the contract, the buyer may have to make higher payments if the profits aren’t high enough to meet the required minimum amounts for a year.
• Risk of litigation: If the details of the earnout provision aren't clearly spelled out, it could lead to a lawsuit over what should be paid.
  

Getting Help with an Earnout

If you are buying or selling a business and you are considering an earn-out, be sure to get advice from your financial advisor, tax advisor, and your attorney. An earn-out is a complex agreement and all the elements must be considered carefully. 

Frequently Asked Questions (FAQs)