Understanding Earn-Outs

Let's break down something that can be a real game-changer in the sale of a business: the earnout. Now, this might sound like just another piece of the puzzle, but trust me, it's where the stakes get high and the magic can happen.

So, what's an earnout? It's a clause that says, "Hey seller, if your business hits certain financial targets after the sale, you get more money." Simple, right? But the impact is massive.

Why do we even need earnouts? Well, when buyers and sellers can’t agree on the current value of a business or its future potential, the earnout can bridge that gap. Sellers often dream big with their valuations—they've poured their hearts and souls into their businesses and want to see that reflected in the price. On the flip side, buyers are cautious, thinking about future performance and risks.

Disagreements over valuation can kill deals, but earnouts keep negotiations alive by balancing risk and reward. Here are the core components of an earnout:

-       Financial Goals: What targets need to be hit?This is usually tied to sales or earnings.

-       Timeframe: When do these targets need to be achieved? Also, what accounting rules are we using to measure success?

-       Compensation: How much extra money does the seller get if they hit the targets? And who from the seller’s side gets paid?

You’ve got to nail these down to make sure both parties feel it's a win-win. Earnouts also make a ton of sense if the business hits a rough patch—like, say, during the COVID-19 pandemic. Sellers might want to be credited for what the business would normally achieve if not for extraordinary circumstances.

An earnout ties part of the sale price to future performance. This could be financial targets like revenue or EBITDA, or even nonfinancial milestones like landing a key client or getting regulatory approval. Earnouts are fantastic for either bumping up the sale price for sellers or addressing risks found during due diligence.

We see earnouts a lot when sellers have been investing in growth that’s not yet showing up in the profits. Think new product lines or services just hitting the market. We tell our clients, "The buyer pays you now for what you've done and tomorrow for what you will do." That's the essence of an earnout.

So, how do you typically structure this in a deal?

How they Work

First off, an earnout usually starts with a base amount paid at closing. After that, you might get a one-time lump sum or installments spread over a few years. Traditionally, we’re talking three to five years. The whole deal hinges on your business hitting certain financial milestones after the sale.

The beauty—and the beast—of earnouts is their flexibility. You can structure them in countless ways, but that also means things can get complicated. The key is to focus the earnout on areas where you, as the seller, still have some control after the sale. And keep it simple. If you're bogged down in arguments about the earn out post-closing, you're wasting valuable time that should be spent growing the business.

Buyers often use earnouts to keep sellers engaged and motivated during the transition period. They want you to stick around and ensure everything runs smoothly. Private equity firms might also use earnouts to spread out the purchase price. This can make the whole thing pretty complex.

In our experience, we value businesses based on a multiple of EBITDA or SDE and then allocate part of that total price to an earnout. This earnout is contingent on the business hitting certain financial targets after the deal closes. We usually hold investments for about five years, and earnouts typically get paid out a year or two after closing. We use them as a form of downside protection, to guard against any early stumbles post-acquisition.

Remember, the goal with an earnout is to create a win-win scenario. You want to ensure you get a fair deal for the business you’ve built while also setting up the new owners for success.

Earnout Provisions on the Rise

We've been seeing a big uptick in the use of earnout provisions lately. Why? Because they're a killer way to keep deals on track. Private equity firms are jumping all over the lower middle market like never before, and earnouts are playing a huge role. The American Bar Association’s Private Target Mergers and Acquisitions Deal Points Study shows that about 27% of deals now include earnout provisions. For smaller businesses, that percentage is even higher.

At our shop, we’re big fans of earnouts. We include them in many of our LOIs because we want the management team to stick around and be pumped to hit it out of the park after the deal closes. TheCOVID-19 pandemic in 2020-21 was a real curveball, hitting businesses hard financially even as the M&A market stayed hot. We turned to earnouts as a way to share risk while still meeting sellers' valuation expectations. And we’re pretty sure we weren’t the only ones doing this.

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Future Impacts

So, what does this mean moving forward? The increased use of earnout provisions could shake things up big time for the banking and legal industries in the small business market.

One thing’s for sure: earnouts are a hotbed for litigation. The litigation folks might be rubbing their hands together, but M&A attorneys? Not so much. They have to think through every possible 'what-if' scenario, and that's a tough gig. Meanwhile, banks might be giving a thumbs up to earnouts. Why? Because it’s not a guaranteed payout, and it helps manage the key risks identified in the business.

In the end, earnouts are here to stay. They’re a powerful tool in our M&A toolkit, helping us bridge the gap between buyers and sellers, and keeping everyone aligned post-deal. Keep an eye on this space, folks—it's going to be an exciting ride.

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