Earnout (Sale of Business) - Explained
What is an Earnout?
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Table of ContentsWhat is an Earnout?How does an Earnout Work?Example of an EarnoutAcademic Research on Earnouts
What is an Earnout?
An Earnout applies in situations where one company is purchased by another. Generally, it is an agreement where the buyer of the company agrees to pay the seller additional funds (above the purchase price) if the firm performs at a given level over a specified period following the sale.
An Earnout agreement is generally used when the buyer and seller cannot agree on the likely future performance of the company. The current and future company performance is used in calculating the company value or sale price.
Executing an earnout agreement allows the parties to share the risk regarding how the company will perform after the sale. If the company performs well, the seller will receive additional funds (representing a higher sale price though the earnest is generally a fixed amount or percentage of revenue). If the company performs below a certain level, the buyer receives the benefit of the original, lower price.
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How does an Earnout Work?
There is no specified formula or yardstick to measure Earnouts. The amount or metrics of determining the earnout may depend on many factors, such as size of business, market share, past revenue, etc. Several issues when considering an earnest include:
- Executive Employees - Will employees and other key position holders of the firm be allowed to take part in the earnout?
- Length of Contract - An earnout depends upon companys future earnings. The contract should identify the applicable time period for measuring performance.
- Performance Metrics - The earnout agreement will identify the metrics that must be achieved for the seller to receive an earnout. Profitability and revenue are the most common metrics. As such, the agreement should prescribe what accounting principles will be used to determine firm revenue and profitability.
Example of an Earnout
Lets assume company XYZ has $10 million in sales and its profits are $1.5 million. The seller wants to sell the company for $30 million (3 times revenue and 20 times profits). The buyer wants to acquire the company for $20 million (2 times revenue). In this case an Earnout can be used to overcome their difference. Both seller and buyer can negotiate an agreement for $20M purchase price and a potential $10M earnout if the company achieves specified sales over four years. The agreement would incorporate specific language that would allow for the payment of the $10M difference if the company achieves specific performance objectives over a specified period of time.
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