When it comes to selling a small or medium-sized business, there is a different option a business owner can consider: an earnout. While an earnout can help the buyer and seller agree to terms, this sort of business agreement is not without its risks. As such, here is a rundown of earnouts, the pros, the cons, and what to watch out for.
Pros: Bridges the Gap & Gets a Deal Closed
Commonly used to either bridge a funding gap or when the future performance of a business is uncertain, an earnout allows the current business owner to receive a share of the future profits of the business for a specified period – usually between six months and two years.
The structure is straightforward. The current business owner accepts an initial payment, usually around half of the company’s agreed upon value, with the rest to be paid out as a percent of the profit over the ‘earnout period’.
While this is often considered a good deal for both the buyer and seller, there are a few things one should know about earnouts prior to agreeing to one. As mentioned, an earnout can be used to bridge a funding gap. But it can also be used when the buyer and seller have a difference of opinion over the financial performance of the business.
While an earnout might sound like a good idea – after all, the structure can be used to close a deal – the devil is often in the details.
Cons: Measuring Performance Can be Tricky
Agreeing to an earnout value is only the first step. One of the keys to receiving a full payout is determining how performance will be measured. This can be a tricky exercise as both the buyer and seller are seeking to reduce risk. The result is the structure of the earnout agreement can become so complex that it is impossible to monitor.
How does this happen? It is usually because an earnout is tied to the net profit of the business and this can get muddied once the new ownership begins to execute their business plan. In addition, the process of measuring profitability can be complicated by market forces, such as when both businesses compete against each other.
Beyond this, there is also the matter of deciding who will measure performance and how it will be done. Based on experience, the simplest way is to pick a starting point and then have the buyer and seller determine their targets for the business based on how it is operating today, without the complexity of factoring in additional investments. In this way, the measurement of the business can be based purely on current operations.
Agreeing to who will measure performance can often be a difficult process. Usually, the best course of action is to bring on a third-party auditor to review the numbers. Keep in mind that even this scenario will not work in every situation since measuring an earnout in a business which needs significant capital investment post-transaction is difficult at best and as such is usually a process of give and take.
What to Watch Out For
Another potential issue when it comes to executing earnouts is that the buyer and seller are often approaching the transaction from different perspectives. While this is normal, the fact that an earnout requires a continuing relationship can bring these conflicting priorities to a head.
For example, the seller might want the business to be steered towards a profit target – after all, this is how they will maximize the deal’s value. However, the buyer might be more focused on post-acquisition integration including the boost that the seller’s technology or customers will give to the business overall.
Contact Beal Business Brokers and Advisors to learn more about earnouts and how they could be used to sell your business.