An earnout is a type of payment agreement which is sometimes used when companies are sold. Under an earnout agreement, the seller receives part of the purchase price up front, and additional funds over time. The terms of the earnout are written into the sales contract, and the earnout can be structured in a number of different ways. Because earnouts are complicated, lawyers are usually consulted when they are constructed to ensure that buyer and seller are both well served by the agreement.
Classically, companies reach such an agreement because there is a dispute about the value of the company being acquired. The buyer may not want to pay the full purchase price up front, due to concerns that the company may fail to do as well as expected. Under an earnout agreement, the buyer might offer to pay, for example, 80% of the purchase price at the time of sale, and the remaining 20% over a period of five years.
Usually, the structure of the agreement requires companies to reach certain milestones in order for the earnout to be occur, and the earnout is often structured as a percentage of gross profits. For example, the agreement might state that the company needs to make a set amount of money before the earnout will occur, and that the payments will constitute five percent of gross profits. Gross profits are used as a measure of performance rather than net profits to avoid concerns about the manipulations of expenses which could be used to reduce the amount of the payouts.
The agreement may also include a clause which states that the seller needs to remain with the company. For some sellers, this can be a difficult clause to fulfill, as they may want to break free of the company to pursue other things, or they may be frustrated by the management style of the buyers. Though they remain with the company, the sellers do not usually have influence or control over the company's policies, and they may grow frustrated if the company radically changes direction under new owners.
For buyers, setting up an earnout reduces the risks of a purchase. Especially when a market is hot, it may be tempting to overvalue companies, and the potential of paying too much for a company is a very real risk. By establishing a payment plan based on company performance in the future, buyers can protect themselves from unwise purchasing decisions. Sellers, on the other hand, can benefit from an earnout because they can earn more over time from the sale if the agreement is structured well and the company's performance is strong. However, sellers also run the risk of not obtaining the full purchase price if the company performs poorly.
