By Gal Barzilay
An earnout is a performance-based bonus paid out over time, commonly used after selling a business. It benefits both buyers and sellers in M&A deals for several reasons:
Risk Mitigation: An earnout helps buyers mitigate the risk of overvaluing a business. By linking a portion of the purchase price to future performance, buyers ensure the business meets expectations before paying the full amount.
Alignment of Interests: The earnout aligns buyer and seller interests. Sellers are incentivized to stay engaged and motivated, striving to achieve agreed-upon targets since their compensation is tied to the business's success during the earnout period.
Bridge Valuation Gap: In cases where buyers and sellers have differing opinions on the business's value, an earnout serves as a compromise. Sellers receive additional consideration if the business performs well, bridging the valuation gap.
When structuring an earnout, consider these key factors:
Define Clear and Measurable Metrics: Base the earnout on specific, measurable, and attainable metrics to avoid ambiguity or disputes. Common metrics include revenue targets, gross margin, or customer acquisition goals.
Establish Realistic Targets: Set challenging yet achievable targets to avoid unnecessary tension. Analyze historical performance, industry benchmarks, and growth projections to determine the earnout targets.
Include Milestones and Timeframes: Divide the earnout period into milestones or interim targets. Regular evaluation and payment occur based on achieving these milestones. Clearly define timeframes and corresponding earnout payments.
Determine Payment Structure: Structure earnout payments based on a fixed amount for each milestone achieved, a percentage of excess revenue or profits beyond the target, or a combination of both. Include payment terms, frequency, and potential caps or limits.
Address Contingencies: Account for potential contingencies that may impact business performance and earnout payments. Consider changes in market conditions, industry regulations, or unforeseen expenses.
Draft a Clear Legal Agreement: Work with legal professionals to draft a comprehensive and legally binding earnout agreement, outlining terms, conditions, metrics, payment structure, and other relevant provisions.
Communication and Transparency: Maintain open communication between buyer and seller during the earnout period. Share financial reports, operational updates, and progress towards targets regularly. Transparency builds trust and reduces disagreements.
In conclusion, earnouts are valuable tools in M&A transactions, fostering alignment and addressing valuation discrepancies. By structuring earnout agreements with clear metrics and realistic targets, both parties can benefit from the business's ongoing success post-acquisition. Seeking professional advice ensures a fair and mutually beneficial earnout arrangement.
Why did we build boosst?
It can be a very difficult process to buy or sell a business, both financially and emotionally. We built boosst so you would never feel alone in the process. We believe that we can empower founders and give them insightful data in order to create their future according to their terms.
Looking to sell your business? Check out how boosst can help.
Looking to buy a business? Check out how boosst can help.
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About the Author
Gal Barzilay, Co-founder and COO of boosst. Gal is a former software engineer who has experience working with global banks and developing tech solutions for eCommerce brands such as Adidas, L'Oréal, and HP. She grew up with two parents who owned small businesses, when they wanted to retire, they couldn't find anyone to continue their companies.
Connect on LinkedIn > here
