New Venture Lab: Equipping Christian Entrepreneurs

Question

Do you have anymore information on the structure of an "earnout" buyout?

Answer

Please see our definition of Earnout in our Glossary for starters.  An earnout structure can take on many forms and can run the spectrum from a simple structure to a highly-complex structure.  The earnout amount is usually paid in either cash or equity.

 

I like to use an earnout structure whenever possible because of the following upsides:

• The Seller shares risk with the buyer
• It minimizes the cash down payment
• It can be used to give the seller a higher purchase price if the business performs well

Some potential downsides of an earnout structure:

• It can set the seller up for a disappointment if the actual price eventually paid is lower than he expected
• It can be difficult to negotiate and document

Some tips on using an earnout:

• Structure the earnout payment as a royalty tied to company performance, rather than as non-recourse debt
• Only pay cash for what is tangible or “bankable” about the business and use an earnout to pay for the "blue sky" potential (intangibles or uncertainty)
• Pay the earnout only after it has been earned and collected

Additional tips from an Inc. Magazine:

• Keep financial formulas simple. "I've seen some arrangements that are so complicated that they wind up backfiring because no one can figure out exactly what they're supposed to accomplish and how it will affect their payout," warns Robert Untracht, a partner at the Century City, Calif., office of Ernst & Young. Include in the design stages of the earn-out accountants, lawyers, and all executives involved.
• Avoid long-term-growth disincentives. "You've got to make certain the earn-out and its resulting pressure for short-term results don't discourage former owners from doing things like spending money on research and development, diversifying, or investing corporate funds in other ways that will produce results only over the long term," warns Klein. Brajdas skirted that risk by guaranteeing Cypress's former owners that "new acquisitions or other long-term investments would be considered as separate from the earn-out agreement -- so that they wouldn't reduce the risk of future payouts." You might also consider using an outside board or financial consultant to evaluate all management decisions to make certain that long-term goals remain important.
• Weigh the costs versus the rewards. "Earn-outs may produce exactly the wrong kind of results for you, depending on the type of company you're purchasing and your own financial goals," warns Untracht. "If it's a fast-growing business, an acquiring company may want or need to plow all the cash back into growth -- and may not actually care about short-term performance." In such cases, it makes better sense simply to negotiate a purchase price that satisfies all parties.  Source: Inc.com

Using the numbers in a previous post where the seller's price expectations were considerably higher than the buyer's sense of the value, an earnout could be structured as follows:

• The value gap:
  • Seller's "ask": $1.7m - $2.3m
  • Buyer's "bid": $1.2m - $1.8m
  • Total gap: $0.5m
• Example deal:
  • Total price of $2.0m (pick a middle range to build goodwill with the seller)
  • Total base price of $1.2m (pick the low end of your value range to be fair, but not over-commit in case there are negative post-closing surprises)
    • $300k cash at closing
    • $900k seller note guaranteed by the business assets and the buyer's personal guarantee
  • Total earnout of up to $0.8m based upon a percentage of sales over a given growth rate or hurdle.  For example, since the business has grown 70% historically, you might structure it as 25% of revenue for any revenue over 50% growth rate paid annually within 60 days of the end of the year.  I picked 25% since the business example has bottom line earnings of 50%+ (which is far higher than typical.)  In a typical business with 10% earnings, you would likely not want to go over a 5% revenue-based earnout.

Example earnout agreement language (written as if it is extracted from a full Purchase Agreement with proper definitions, etc.) for the above scenario:

Determination of Earn-Out Amount. On or before the 60th day following the conclusion of each of the next three (3) calendar years, beginning with the year ending December 31, 2008, Buyer shall determine the Revenue of the Company for the calendar year just ended. For purposes of this calculation, the parties agree and understand that the year ending December 31, 2008 only includes the months of August, September, October, November and December, 2008.  The amount of Additional Compensation to which Seller is entitled to receive for each of said calendar years shall be a sum equal to twenty-five percent (25%) of the Revenue for that year, provided however, that the cumulative sum of all of such Additional Compensation shall not exceed Five Hundred Thousand Dollars ($500,000).  Buyer shall pay Seller the Additional Compensation within ten (10) days after the calculation of Additional Compensation is made for each of such calendar years.