Sometimes prospective buyers and sellers have different views about the valuation of a business. It is not uncommon for sellers to put a high valuation on their business, especially when they have spent many years of their lives building the business to where it is today. Disputes over valuation can kill a potential deal. An earnout also makes sense when a business is hit with a challenge that doesn’t reflect normal business performance.
One way to overcome this impasse is by putting an earnout provision in the contract. An earnout allows the seller to secure additional compensation in the future if the business achieves certain financial goals.
The key elements of an earnout include financial goals, timeframe, and the amount of additional compensation. The earnout provision states the financial goals that need to be met before the seller receives additional compensation. The amount of additional compensation is usually stated as a share of gross sales or earnings. The provision also includes the timeframe in which these goals need to be met using accounting principles to establish performance criteria.
Earnouts can also be used when the seller has implemented growth initiatives, such as a new product line or service, where expenses have been incurred but revenue and profits need time to materialize. The earnouts are based on the business achieving certain financial milestones in the future.
Buyers often use earnouts to their benefit by incentivizing sellers to stay on after closing to ensure a successful transition.
Although there are many ways to structure an earnout, it is a good idea to keep the earnout calculation as simple and clear as possible. This provision typically includes a base amount to be paid at closing and a one-time lump sum or installments over a set period of time. This set period of time has traditionally been 3-5 years, but this window has been narrowing.
Earnout provisions are a proven way to keep a deal on track. As a result, the implementation of earnout provisions in business sale contracts have grown over the last several years. It is a means of risk-sharing while also trying to meet the seller’s valuation expectations.
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