It’s true: earnouts typically benefit buyers. But here’s something else that’s equally true: sometimes earnouts can be positive for sellers.
Why the paradox? In short, because it depends. While sellers may commonly perceive earnouts in a negative connotation, there are times when a seller should be excited for the opportunity presented in an earnout. Some of those situations might include:
- The seller’s business is experiencing particularly high growth.
- The seller’s business has value that will be realized soon but isn’t reflected in historical financials, such as newly signed contracts or newly opened facilities, and the only way to reach a deal is to show the seller that they won’t compromise on valuation but selling prior to realizing this value.
But before we get too far into particular examples, let’s examine a pair of important preliminary questions:
- What is an earnout?
- Why an earnout? In other words, why would a buyer incorporate an earnout into a deal at all?
What is an earnout?
An earnout is a tool used to bring a buyer and seller closer together when they cannot agree on a price. That price is tied to the business’s valuation, so a disagreement on price is a disagreement on valuation. This misalignment stems from the buyer failing to agree that a business will continue to generate the return upon which its valuation is calculated.
An earnout is a hedge of sorts—it’s a contractual condition in which a buyer and seller agree on a target for business performance (typically revenue or cash flow) that a seller must achieve within a determined timeline (typically 1-3 years) to receive a payment from the buyer (cash or equity).
If a seller’s valuation is correct, so goes the logic of an earnout, then prove it.
Why an earnout?
There are other tools and incentives designed to entice similar outcomes (i.e. deferred payouts, equity packages, partnership models, and more). If earnouts are inherently designed to benefit buyers, why would sellers agree to them in the first place?
A predominant reason is timing. If a seller is ready to exit and not willing to wait a year or two to grow, then an earnout is an enticing proposition. Or maybe a seller is wary of future market uncertainly, or a looming recession cycle, or potential tax changes? Why grind out several more quarters of meticulous financial record-keeping and foot-on-the-gas growth targets when they could hedge now? Finally, a seller might not want to give up value they feel their company has already created, even if that value has not yet been fully expressed in the financials.
When should sellers be excited for an earnout opportunity?
Now we’re back to our original “it depends” statement that not all earnouts are the same. There are myriad structures and just as many outcomes. While we would hardly issue a blanket advisory for clients to accept earnouts, we have advised on several deals where the terms of an earnout benefited the seller.
In one recent transaction, the seller had several sources of unrealized value. This included multiple offices in the midst of construction and expansion and additional identified de novo locations. With all these factors in play, our advisors structured a deal to give the seller the same EBITDA multiple on incremental EBITDA for each of the first two years after closing, paid in the combination of cash and rollover equity as they received at closing. For the seller, this resulted in several million dollars of additional purchase price over those two years.
We have other examples in which our advisors structured earnouts to our clients’ advantage. In one in which the seller was in a similar position as the aforementioned example, the seller was able to take home 50% of all incremental revenue—uncapped, so there was a clear incentive for the seller to pursue high growth and performance. In another example, the seller had signed contracts for increased prices from customers for the upcoming year, and as long as it retained those customers it would receive a significant payment one year following the closing to effectively true it up to a valuation reflecting this growth.
What’s the downside of earnouts?
That said, there are examples we’ve collected from across industries that are more typical, where earnout structures are enormously biased toward buyers. One of the strictest stipulations we ran across required the seller to grow both revenue and EBITDA by 5% per year just to receive the full purchase price. Even stricter was that it was all or nothing—there was no catch-up provision. So the seller had to hit the 5% growth target or get none of the payment promised in the earnout.
Other terms we’ve seen call for holding 90% of revenue, which seems like a more generous target than in the previous example, but in reality, even a neutral growth target (revenue just can’t go backward) benefits the buyer.
In the end, it’s important for sellers to remember that while earnouts can be an enticing and ever more present fact of today’s deal structures, they will typically favor the buyer. So what can sellers do? It may come as no surprise, but it’s crucial for sellers to have an advisor on their side. For many middle-market business owners, they’re being pursued by large, intensely competitive buyers. These groups invest immense resources that give them an edge. It’s how they maintain an information asymmetry that benefits them at the expense of the seller. Caber Hill Advisors helps to level the playing field and ensures sellers’ considerations are balanced appropriately across all terms of a deal, particularly when it comes to something as precarious as an earnout.
