In my experience, earnouts are often used where there is a gap in price between what a buyer is willing to pay and what a seller is willing to accept. In these cases, buyers and sellers can often have legitimate differing opinions as to the current and future value of the target company. Additionally, the metrics of the earnout often require the seller to deliver strong financial results in the future in order to justify the payments on the earnout.
While an earnout remains a valid option to fill a valuation gap, at Third Coast we have worked with our corporate acquisition clients to use earnouts as a form of deferred purchase price instead of a reward for achieving projected future performance. The idea is to make the earnout a part of the purchase price as opposed to being in addition to the purchase price. The premise is as follows-if the seller delivers financials results that are consistent with the performance of the business during the most recent year before closing, the earnout will be paid. To make this straightforward and simple, we typically base the earnout payments on a percentage of the gross profit dollars produced by the business. The percentage amount is set at a level that will allow for most (if not all) of the earnout to be paid over 2-3 years based on achieving the historical level of gross profit. To create an added incentive for the seller, we also allow for payments to be in excess of the deferred purchase price (“earnout”) if they exceed historical levels of gross profit.
The advantages of this structure to the buyer include:
1) an incentive for the selling owners to successfully transition the business and the clients;
2) downside protection in the event that the business performs poorly in the first few years; and
3) an opportunity to pay for some of the purchase price over time.
The advantages of this structure to the seller include:
1) an opportunity to earn more than the original purchase price for the business;
2) the ability to improve company performance by being part of a larger organization with greater resources; and
3) a chance to continue in a prominent role at the company to ensure continuing success.
This type of structure does not fit all situations and all types of businesses, but it does work particularly well in services businesses or at companies where management continuity and client retention is critical to the success of the acquisition from the buyer’s point of view.