Importance of An Earnout

During any M&A transaction, disagreements between the buyer and the seller are quite common, especially regarding the purchase price. The seller usually expects a higher price with their best interest in mind, and the buyer normally wants to pay a lower price. 

Of course, both parties will have their documents, proof, arguments, and computation to justify the price that they want. If both parties decide to compromise, they will arrive at a number they are happy with and close the deal. However, when both parties refuse to budge with their prices, then that is when earnouts are used. 

Earnouts are an agreement to pay additional amounts in the future if certain conditions are met. There are two reasons why the buyer would want to execute an earnout. The first one is to bridge the valuation gap between parties. As mentioned above, if both parties cannot agree on the price, then an earnout will be executed as a promise to pay additional money if the seller's valuation is correct. This could be attaining a specific revenue or retaining certain contracts or customers. 

The second reason why the buyer would execute an earnout is to align economic incentives with the seller. If a non-compete is unenforceable, an earnout can be used to protect the buyer. This can also be used to prevent the seller from damaging the business, as additional compensation will be given if the business is thriving. 

Earnouts could also be used to keep the seller involved in the business. But in this regard, you have to be careful as this can easily be construed as compensation, rather than an earnout. 

Because of the nature of earnouts, disputes and litigation is prevalent. You are tying up a considerable amount of money based on performance to be achieved years from now while integrating them into your business. This is why earnouts have gotten a bad reputation over the years.

Having said all that, there are ways you can make earnouts effective and successful. With the proper metrics and deal structure, earnouts can be peaceful. Helping us uncover how to make earnouts work is Edward Hamilton, Managing Director at VRC. Catch him in the M&A Science Academy with other practitioners to help you perfect your M&A process.