Earnouts: Are They For You?
An “earnout” is a specific condition of a sales agreement that provides compensation to the seller based on the growth of future revenue and/or profit by the seller’s company. Like any post-transaction condition, earnouts should be carefully considered and they may make sense in the following scenarios:
- The seller has a rapidly growing company that will not be “fairly” valued based on past earnings.
- The buyer wants to incentivize the seller to stay and continue building the business.
- The buyer has limited financial resources, but could use future cash from the business revenue growth to boost the initial transaction payment.
- The seller has strong referral relationships that the buyer believes can be leveraged to accelerate growth and profitability.
There are other scenarios in which an earnout might make sense, but essentially earnouts address a gap in perceived value at the time of the transaction.
The challenge for most buyers and sellers are the post-transaction relationship requirements for a successful earnout. Fundamentally, the agreement relies on specificityand trust. While tax implications and other operational concerns can play a role, the earnout condition requires both parties to be very specific in articulating the earnout contingencies and agreeing to discuss the details as they unfold. Sellers who are intent on leaving their business as soon as possible post-closing are typically bad candidates for earnouts.