Don’t do it, get cash at closing
The most important dynamic to remember when structuring an earnout is that by definition, it is contingent, and should be avoided when possible. If it becomes an unavoidable element of the consideration, it should be viewed as potential incremental value and not necessary to the overall logic and merit of the transaction. In other words, it should be considered the frosting on the deal.
However, the value of your business is largely in the eye of the beholder. Cautious buyers might not offer a value that meets your goals. It’s never easy to negotiate a sale. When seller expectations can’t be met, an earnout provision can help narrow the difference between two sets of expectations.
With earnouts, the original owners often remain with the company following a transition period. The contract then incentivizes them to support the business’s success by offering them a share of the profit. Earnouts protect buyers from overpaying for companies. This strategy is intended to smooth the transition period. By keeping sellers invested in the deal, an earn out can ensure a business continues thriving.
Setting Realistic Expectations
Disagreements about the value of a company usually relate to beliefs about the company’s future growth. Consider why you are optimistic about future value—and the extent to which you are willing to stake your future on this optimism. Most earnouts are directly tied to performance in sales, earnings, or a similar benchmark over three to five years. We advise clients to push for earnouts based upon revenue if possible, minimizing the risk of negative profit manipulation impacting earnout value.
So, before you begin negotiations think about your company’s health over the next few years. Consider whether your company has historically met, fallen short of, or exceeded expectations and forecasts. This information can help you negotiate a deal, particularly if your company traditionally outperforms expectations.
Simple Earnout Structures are better
For owners hoping for a quick sale, the quickest earnout structure is no earnout at all. Any sale involving future conditions is a risky one, particularly when the owner must live by someone else’s rules.
Earnouts often depend on a matrix of variables that are well outside the CEO’s control. This gamble is one most CEOs want to avoid. The best earnout is one that depends on only one or two simple variables that are substantially within the control of the CEO. Be wary of buyers who wish to construct complex earnouts with multiple variables. Instruct your team to seek a simple deal with clear metrics. Take a lead from industry giants – even Google says it now shies away from complex earnouts.
How to Avoid Earnout Burnout
Stay true to your priorities as a business. Ensure that key components of your success remain in place. Some tips to help your earnout work for you include:
- Retaining key team members.
- Insisting upon the shortest possible contract term.
- Retaining as much control as possible.
- Seek a sufficiently high earnout to motivate you to succeed.
The buyer should never be the only party determining the terms of the earnout. Both parties must carefully vet the earnout agreement with legal and financial specialists.
Ensuring Success and Avoiding Disaster
Addressing a few simple questions can keep the agreement comprehensible and prevent many common earnout pitfalls. Those include:
- Will the CEO of the acquired business maintain sufficient autonomy?
- Is the earnout strategic or financial?
- Who is the umpire charged with judging progress?
- What happens if factors beyond the parties’ control alter the outcome?
Critically evaluate each of these queries with your team. Each party should have substantial say over the final agreement, so come to the negotiating table ready to work—and prepared to draft a comprehensive, and comprehensible, agreement.