What is Earnout?
Earnout is a financial arrangement made between seller and acquirer wherein the seller will receive additional compensation if the business under consideration achieves specified financial goals. Generally, these financial goals are stated as gross sales percentage or earnings.
Often this earnout payment is used to bridge the valuation gap. If a person is selling the business is asking more price than what is asked by the buyer, than in that case, such provision is helpful. The seller gets paid only if the predetermined future level of EBITDA or financial targets, as decided by the parties concerned, is achieved.
Examples of the Earnout Payments
X Ltd is running a business of the textile in which during the last financial year, sales were $ 400 million, and the earnings were $ 100 million. There is a person Mr. Y who wants to buy the business X ltd. at $ 200 million. The owner of X Ltd is also ready to sell his business, but he believes that this price is very low, and it will also undervalue the future growth prospects of the business.
So the owner asks for the $ 400 million as the price for his business, which Mr. Y denied agreeing. To reach to a solution and bridge, the gap parties decided to use an earnout method where it is decided that the upfront cash payment will be made of $ 200 million to the seller or the owner of X ltd by Mr. Y and earnout payment of $ 200 million will be given in case the if the earnings reach at the level of $ 300 million with the period of four years window or else $ 100 million will be given as the earnout money to the seller if the sales reach the level of only $ 150 million and if these targets are not met then the seller will not be paid anything in future.
It is the example where the two parties made the financial agreement with each other. One party decided to sell the business to the other party on the condition that some money will be paid upfront and some, if a predetermined future earning level is achieved. It helped in bridging the gap between the buyer and the seller of the business.
X is the owner of the business of bakery and has the valuation expectation of $ 50 million of the business. One buyer approached him, but he is ready to give only $ 35 as the purchase price as, according to him, this is the correct valuation of the business as per the current market conditions prevailing.
Both parties have their expectations, leading to the gap of $ 15 million ($ 50 -$ 35 million). Now both the parties decided to bridge this gap with the help of the Earnout where it is a financial arrangement made between the parties to purchase a business where the seller finances some portion of the purchase price, and the payment of the financed amount back to the seller is contingent on getting predetermined future earnings level.
So in the present case, it is decided that the seller will get paid $ 5 million per year for the next three years in case the business under the new buyer achieves EBITDA of $ 25 million per year.
- Earnout helps eliminate uncertainty for buyers as he will have to pay only if a certain level is achieved. It is also beneficial for the seller as he will also receive benefits if the business achieves growth in the future.
- There is no hard and fast rule in the case of the Earnout; instead, the level of the payout is dependent on the number of factors such as the size of the business, etc. So, it is very helpful in bridging the gap if it exists between the parties (buyers and sellers) having different expectations from each other.
- Earnouts Payments are complex as it requires careful consideration of the milestones or the metrics that will be required and ensuring that appropriate incentives are there for a mutual benefit like proper aligning of incentives among the concerned parties, consideration of proper milestones, etc.
- It requires the careful drafting of everything, including drafting of definitions and covenantsOf Definitions And CovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements.. All the terms and conditions have to be drafted properly, as even a single confusion can cause the problem and confusion among the parties in the future.
Important points of the Earnout
- It is a contractual provision according to which the seller of a business will obtain future compensation if the business achieves certain predetermined financial goals.
- These payments help eliminate uncertainty for the buyer as he will have to pay only if a certain level is achieved and for the seller as he will also receive benefits if the business achieves growth in the future.
Thus it can be concluded that the Earnout provides the opportunity to the seller and the buyer in deciding the mutual price for the financial transaction and bridging the valuation gap. It is a contractual provision according to which the seller in the future will receive additional compensation if the business under consideration achieves specified financial goals. There is no hard and fast rule in the case of the Earnout; instead, the level of the payout is dependent on the number of factors such as the size of the business, etc.
This article has been a guide to Earnout and its meaning. Here we discuss how to calculate Earnout payments for the financial transaction and valuation gap and its advantages and disadvantages. You can learn more about financing from the following articles –