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Crafting an Effective Earnout

By Generational Equity

11/09/2020

Although popular during normal economic scenarios, during times of uncertainty buyers craft earnouts to reduce the potential risk in a deal.

For those of you that have not attended one of our growth and exit planning conferences, an earnout is basically a contractual arrangement where the seller of a business agrees to take part of the buyout of his/her company in contingent payments based on future levels of revenue, earnings, client retention, employee retention, and many, many other metrics. 

A well-crafted earnout can actually benefit a seller (assuming that the forecasted expectations become reality and are adequately compensated for in the agreement). Unfortunately, the reverse is also a very real possibility – a poorly structured earnout, one where the seller has little control and/or inadequate auditing of success, can seriously impact the ultimate payout to the seller.

So, it is vital to have professional representation by your side to guide you through any earnout negotiation – especially during these volatile economic times.

According to a recent article in the Wall Street Journal:

Earnout provisions are making a comeback as investors try to address the market uncertainty caused by the coronavirus pandemic. Earnout provisions allow buyers to defer a portion of a deal’s purchase price over a period of time and tie the remaining payouts to performance milestones agreed to with the seller.

Although they are most commonly used in life sciences deals, earnouts in 2019 accounted for 22% of deals outside of the life sciences space, according to a report published by SRS Acquiom.

I would anticipate once 2020 is tabulated, earnout provisions of all sorts will have made up even more than 22% of deals in all industries.

And the length of the timeframe for the earnout can vary as well. According to the WSJ over 70% of the earnouts tracked were between 1-5 years. That means that a seller is on the hook for performance metrics for a long, long time.

Again, this is why having professionals working on your behalf is so important as you negotiate with buyers regarding any type of deal structure. If you are not a professional dealmaker and you have not successfully sold a company in the past, trust me, you need guidance to prevent a buyer taking advantage of you with an earnout scenario that ultimately hurts your total payout. 

Some key questions you should consider as you discuss an earnout scenario include:

  • How confident are you in the company reaching its projected numbers?
  • How much control will you have over the organization’s performance post-sale?
  • Will the new owner be replacing your management team with his/her own?
  • If your payout is contingent on the retention of key clients/customers, how much impact will you be allowed to have on this metric?

Ultimately in a win-win earnout negotiation, you will be able to exert meaningful input and have a direct impact on your final payout. Of course, the goal of any earnout is sharing risk. You share the risk with the buyer about the assertions you and your team have made about the future, and the buyer shares with you the risk that these things may not occur.

This is why we strongly insist that our clients create accurate and meaningful projections for revenue and profit going forward. If your company has been growing 5% per year and has a profit margin of 10% for the last 10 years, suddenly projecting 20% growth and margins improving to 30% will only force an earnout upon you. This is especially true in our COVID-impacted business world. 

As we have discussed before, EBITDAC recasting (earnings before interest, taxes, depreciation, amortization, and COVID) is very legitimate IF you can accurately document the impact that COVID has had on your business and the strategies you have implemented to overcome the impact of the pandemic on your operations. Both are key and again, highlight just how vital professional representation is when you plan to exit your business.  

Our team has closed well over 900 transactions and we are well on our way to the 1K mark. We are able to monetize our clients’ businesses no matter what economic cycle we are in because of the skills of our deal team and their dedication, persistence and hard work. 

Just don’t take my word for it – listen to what a few of our clients have said about our services:

In conclusion, I will say this to you: If you want to MAXIMIZE your ROI when you exit your business, you need to hire professionals. Don’t go cheap – realize that your financial future is worth more than you can imagine.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

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