Updated: May 21, 2022
There are countless reasons why buyers and sellers seldom agree on a business’s valuation when it is put up for sale. For this situation, the two parties should consider instituting an earnout provision. In the context of a business transaction, an earnout agreement is a provision in a contract that allows the business’s seller to gain compensation in the event that the business hits certain benchmarks after the sale.
One of the main purposes of earnout financing is for the buyer and seller to find a middle ground if they disagree on the appropriate asking price. The source of a dispute that may be alleviated by instituting an earnout agreement is that the buyer and seller disagree on the financial potential of the company. Earnouts help reduce the risk for the buyer in addition to motivating the seller to leave the company in a favorable position.
Let’s say the founder of a startup is open to the suggestion of selling the company. The founder strongly believes that with the right guidance and infusion of cash, the company could be worth $75,000,000 in a few years, so he sets $75,000,000 as of the asking price. A prospect conducts an independent valuation of the company and determines that, while the business certainly could flourish, the appropriate selling amount should be $35,000,000.
After some negotiation, the buyer and seller come to an agreement. The startup will be purchased for $50,000,000 upfront. Three years after closing, the sales amount from the previous year will be examined. For a sales amount of more than $250,000,000, the seller will “earn-out” the remaining $25,000,000 that he originally asked for but the buyer did not commit to upfront. If total sales runs greater than $200,000,000 but less than $210,000,000, then the seller will only “earn-out” $20,000,000 based on the sales tier that was actually reached.
Points of Contention
Determining which criteria to use when assessing whether earnouts should be triggered is something sellers and buyers may disagree on. Buyers might want to base the performance on net income, while sellers often prefer revenue to determine whether benchmarks are hit. Additionally, measures must be taken by the seller to ensure the buyer acts in good faith and does not torpedo the figures that are used.
The buyer and seller of a company are often far apart at the beginning stages of negotiation, but there are contract provisions that can bring the two sides closer together. Earnout financing can be a powerful tool to accomplish this, but you will need the help of an experienced business attorney to ensure the terms are favorable to you. For any help with your business’s legal matters, reach out to Attorney Patrick Monahan today.