Dealing With Earnouts When Selling a Company

A common deal component that buyers use in an acquisition is an earnout. A deal component where a portion of the total payout to the seller is contingent upon the seller hitting certain milestones over a predetermined time post-acquisition. Earnouts are far more common in the sale of services businesses and very asset-light companies. And in my experience, they are by far the most intensely negotiated component of a transaction.

Most CEOs and founders that I work with are squarely focused on maximizing valuation when looking at a potential sale of their organization. And while that is important, the truth is the M&A process is an exercise in risk management for both the seller and the buyer. And for a buyer, they need to ensure that the organization they are acquiring will at least maintain if not grow their existing revenue in order to substantiate the valuation they will be paying. So including an earnout as a component of the deal structure is a way they can mitigate some of that risk. And that's not an unfair ask. However, for a seller that creates some risk because a substantial portion of the total valuation they will be receiving is not guaranteed. So it becomes incredibly important for the seller to address and manage that risk by having the proper earnout structure in place.

The Structure of Earnouts

There are a lot of ways that earnouts can be structured. The majority of the time, earnouts are predicated on maintaining or growing existing revenue. Furthermore, the length of the earnout can stretch over as little as one year to as long as two to three years.?

And while I have seen other mechanisms used such as tying an earnout to growth in net operating income, earnouts focused on revenue growth are the most common. Different buyers will have different post-acquisition goals which will dictate how they structure a proposed earnout. But for the seller, what's most important is that the earnout is fair, attainable, and “market”. ?And what's market will certainly vary from industry to industry and the size of the organization being acquired. Outside of a reasonable structure, maintaining simplicity is also important. Overly complicated earnout structures will only cause problems for both the buyer and seller post-acquisition. Usually, well-intentioned acquirers will begin with a relatively simple proposed earnout structure. And through a poorly managed negotiating process, that simple structure can deteriorate into one that is overly complicated.

Earnouts as an Overall Percentage of The Transaction Consideration

Even though an earnout may be a necessary component of a transaction, it should not constitute the majority of the transaction. The majority of a transaction should come in the form of cash at close, guaranteed payments in the form of a seller's note, or equity.

Outside of situations such as distressed asset sales or a seller with customer concentration issues, an earnout should ideally be no more than 30% – 35% of the total transaction consideration.??

Having Some Control Is Key

CEOs and founders need to accept the fact that when selling their company, they are giving up control on some level and there is a small leap of faith that needs to be taken. And this is especially the case when there's an earnout involved, or they are getting equity in the acquiring organization.

But maintaining some level of control is key. And that control should be centered around their ability to ensure that they can hit revenue targets to achieve their earnout. This is why it is fundamentally important to carve out very specific roles, responsibilities, and expectations in purchase agreements so that a reasonable level of control is protected.

The Importance of Cultural Fit

A good cultural fit and alignment are important in any merger or acquisition for both the buyer and the seller. As it relates to earnouts, ensuring there is some cultural fit is also very important. Having that cultural fit and having alignment around the strategic vision and approach to growth and giving the seller control of their ability to achieve those growth metrics will directly impact how successful they are post-acquisition and whether or not they achieve their earnout in full.

The good news is this is typically relatively easy to flush out during the evaluation and due diligence process. Buyer behaviors such as not being completely forthright, proposing terms that are either unfair or well below market, or being uncollaborative are all red flags. In many respects, the acquisition process is similar to an interview process. A potential employer that sends subtle signs of a bad culture or is trying to hire employees at below-market rates is the telltale sign that down the road, a long-term relationship very well may not work. This is the same case in an acquisition and when it comes to achieving an earnout. I've seen both flavors of acquirers, those who are fair and collaborative and those who exhibit somewhat aggressive and exploitative behaviors. When dealing with the former, the chances of successfully realizing a full earnout are usually higher.

The process of selling a company is fraught with risks for both sellers and acquirers. Earnouts are a common component of an acquisition that can oftentimes add to that complexity and risk. So, sellers must be prepared to navigate the process of ensuring a fair and attainable earnout structure is in place. And even more importantly have more than one offer in place, thereby significantly increasing the odds of realizing not only a strong valuation but a fair and reasonable earnout and deal structure.

I'm the Founder of Drive Equity Advisors, an investment bank specializing in M&A advisory for sellers and acquirers of IT and management consulting firms in the digital transformation space. You can learn more about the work we do at driveequityadvisors.com