Earnout (Sale of Business) – Definition

Cite this article as:"Earnout (Sale of Business) – Definition," in The Business Professor, updated November 22, 2018, last accessed October 19, 2020, https://thebusinessprofessor.com/lesson/earnout-sale-of-business-explained/.

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Earnout Definition

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 earneout 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 ‚ÄĒ 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.

A Little More on What is an Earnout

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 company‚Äôs 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

Let’s 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.

References for Earnouts

https://www.investopedia.com/terms/e/earnout.asp

https://en.wikipedia.org/wiki/Earnout

Academic Research on Earnout

  • ‚󏬆¬†¬†¬†¬† Determinants of¬†earnout¬†as acquisition payment currency and bidder’s value gains, Barbopoulos, L., & Sudarsanam, S. (2012). Journal of Banking & Finance,¬†36(3), 678-694. The paper investigates the revenue effects of an extensive sample of UK bidders offering earnout as compensation for their acquisitions. It provides evidence of the fact that bidders offering earnout optimally enjoy greater announcement and post-acquisition value gains than bidders offering non-earnout currencies. This is further cemented by the logistics model constructed in the paper, to predict when it is effective for a bidder to offer earnout. In conclusion, the paper adds value to the broader literature on how corporate acquirers use payment currency to manage information symmetry and the attendant valuation risk.
  • ‚󏬆¬†¬†¬†¬† Analyzing the likelihood and the impact of¬†earnout¬†offers on acquiring company wealth gains in India, Kohli, R., & Mann, B. J. S. (2013).¬†Emerging Markets Review,¬†16, 203-222. This article attempts to analyze the effect of earnout offers on the remuneration of acquiring companies in cross border acquisition in India. A case study in which the acquirer preferred earnouts in the two scenarios was employed. The consensus reached indicates that despite the fact that earnouts offers are a common factor, it only creates greater remuneration when compared to cash offers and not stock offers (intangible assets).
  • ‚󏬆¬†¬†¬†¬† Earnout¬†deals: Method of initial payment and acquirers’ gains, Barbopoulos, L. G., Paudyal, K., & Sudarsanam, S. (2018 European Financial Management,¬†24(5), 792-828. In the study, the impacts of initial and deferred payments in earnout deals was analyzed. It revealed that the initial payment method produces superior results in cross-border deals than domestic deals. The study concluded that earnout deals generate even greater gains when both initial and deferred payments help spread the risk among the stakeholders of acquiring and target firms.
  • The art of earnouts, Craig, B., & Smith, A. (2003). Strategic Finance,¬†84(12), 44. The earnout is an agreement in which the buyer does not pay the full acquisition price of a company until the company performs in the future. This strategy is used to solve controversy between parties about a business’s performance. Earnouts also encourages the seller to continue to support and build the business. In this paper, the authors exchange their views on the characteristics, application, and secrets of creating an effective earnout agreement.
  • The¬†earnout¬†structure matters: Takeover premia and acquirer gains in¬†earnout¬†financed M&As, Barbopoulos, L. G., & Adra, S. (2016). International Review of Financial Analysis,¬†45, 283-294. This paper uses parametric and non-parametric methods to solve the arduous problem of how earnouts used in corporate takeovers are structured and how it influences the returns received by the acquirers. The article accomplished this in three major steps.
  • Religion and mergers and acquisitions contracting: The case of¬†earnout¬†agreements, Elnahas, A. M., Hassan, M. K., & Ismail, G. M. (2017). Journal of Corporate Finance,¬†42, 221-246. This article discusses the role religion plays in mergers and acquisitions. The authors assert that conditional payments in contracts breach Islamic law and also creates various problems by encouraging managers to partake in degrading behaviors during the earnout periods. The result of the study was obtained by regression and double difference estimations and exposed that managers increase earnings by cutting expenses through the earnout periods.
  • Return of the¬†Earnout: An Important Tool for Acquisitions in Today’s Economy, Levy, K., Bonvino, A., & Amarnani, P. (2011).¬†Bus. L. Today, An earnout is a conditional part of purchase payment that is paid to the seller when the acquired business achieves certain goals within a specific period of time. The use of earnouts reduces the buyer’s risk that it is overpaying for an underperforming business while giving the seller a considerable deal when the goal is reached. ¬†A properly structured earnout leads to a win-win situation for both parties. In today‚Äôs economy, a carefully structured earnout agreement is an important tool to help finalize acquisition agreements.
  • Save that deal using Earn‚Äźouts, Frankel, M. E. (2005). Journal of Corporate Accounting & Finance,¬†16(2), 21-25. The author uses this article to teach readers how to use earn‚Äźouts to reduce the risks of future disagreement and legal problems. Earn‚Äźouts, when utilized well, is a powerful tool. Earnouts solves the question of ‚Äúbid-ask spread‚ÄĚ between seller and buyer in mergers and acquisitions. It‚Äôs very important to weigh the risk of earnouts before use.
  • The pros and cons of earnouts, Del Roccili, J. A., & Fuhr Jr, J. P. (2001). Journal of Financial Service Professionals,¬†55(6), 88. An earnout deal is used to minimize the risk associated with business transactions. Both parties negotiate an earnout deal in which the seller will get additional money if the acquired company reaches certain goals. Whether earnouts will benefit both sides is dependent on the structure of the deal. The paper discusses on the advantages and disadvantages of several earnout structures and gives an example based on actual litigation.
  • The Concept of¬†Earnout¬†in Merger and Acquisition Transactions, Sehgal, A. (2013). The Concept of Earnout in Merger and Acquisition Transactions. This article highlights the results of using earnouts in mergers and acquisitions. It deals with the effect of uncertainty on the right timing of mergers and acquisitions using earnouts. This article also recommends the use of earnouts as an important strategy to minimize overpayment in acquisitions due to inexperience by the acquiring companies. The article seeks to fill the space left in existing literature by fully discussing the effect of the different methods of payments on the risk experienced by acquiring companies in the post-acquisition period.
  • ‚󏬆¬†¬†¬†¬† The valuation effects of¬†earnout¬†in M&A of financial institutions, Barbopoulos, L., & Wilson, J. (2013). Responsible Banking and Finance working paper, University of St Andrews. The study examines the magnitude of change in the announcement period and long-run returns when earnout is used as a payment method for mergers and in financial institutions. The result presents that higher announcement period and long-run returns are experienced by financial institutions that use earnout as a payment method. Therefore, earnout payment methods are more effective than non-earnout payment methods.

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