When selling a business, there are various deal structures that can be used to ensure a successful transaction. One such structure is the earnout deal, which allows the seller to receive a portion of the sale price based on the future performance of the business. In this article, we’ll explore what an earnout deal is, how it works, and the advantages and disadvantages of this structure.
What is an Earnout Deal?
An earnout deal is a type of deal structure used in mergers and acquisitions where a portion of the sale price is tied to the future performance of the business. The seller and buyer agree on a base sale price, but the final sale price is contingent on the business meeting certain performance metrics over a set period of time.
How Does an Earnout Deal Work?
In an earnout deal, the seller and buyer agree on a base sale price, but a portion of the sale price is deferred and paid out over a set period of time, usually one to three years. The payment is contingent on the business meeting certain performance metrics, such as revenue growth, profitability, or customer retention.
For example, let’s say a business owner is selling their business for $5 million, but $1 million of the sale price is tied to the future performance of the business. The buyer and seller may agree that the seller will receive an additional $500,000 if the business meets certain performance metrics over the next three years.
Advantages of an Earnout Deal
There are several advantages to using an earnout deal when selling a business. These include:
- Increased Sale Price: By tying a portion of the sale price to the future performance of the business, sellers can potentially receive a higher sale price than they would in a traditional deal structure.
- Risk Mitigation: An earnout deal can also help mitigate risk for the buyer by ensuring that the business continues to perform well after the sale. This can be particularly useful for buyers who are unsure about the future prospects of the business.
- Motivated Seller: An earnout deal can also motivate the seller to stay involved in the business and work towards achieving the performance metrics needed to receive the deferred payment.
Disadvantages of an Earnout Deal
Despite the advantages, there are also some disadvantages to using an earnout deal. These include:
- Complexity: An earnout deal can be more complex than a traditional deal structure, requiring detailed negotiations and legal agreements.
- Risk for the Seller: The seller takes on the risk that the business may not meet the performance metrics needed to receive the deferred payment. This can be particularly risky if the seller is relying on the deferred payment for their financial future.
- Delayed Payment: The seller may not receive the full sale price until several years after the sale, which can impact their financial planning.
Conclusion
An earnout deal can be a useful structure for sellers and buyers in certain situations, particularly when the future performance of the business is uncertain. However, it is important for both parties to carefully consider the advantages and disadvantages of this structure and work with experienced professionals to ensure a successful transaction. With proper planning and negotiation, an earnout deal can be a valuable tool for both parties in a business sale.