After everything you have invested in your business, you expect a buyer to see a fantastic opportunity with a great return. Shouldn’t the sale price reflect the groundwork you laid for them? All the time, energy, expenses, equipment, training…the blood, sweat, and tears…That was all you. They’re stepping up to a well-oiled machine.
Fair point, and one that is sometimes written into a business sale agreement as an “earnout.”
How it Works
An earnout is designed to bridge the gap between projection and speculation. If a business has a net profit of $500k per year, we would look to sell it at a multiple of that number. Depending on its salability, we’ll say the sale price might be $1.5 million (3x). But, if the business is projected to do $750k the following year, that extra $250k could amount to an additional $750k (3x) in additional sale price.
To be fair to the buyer, who doesn’t know for sure that the business will make more than it does today, we would set the sale price based on the business’ current earnings. The buyer might then agree to pay an additional earnout to the seller if the business does hit the mark that the seller is insisting it will. In the example above, the sale price would be $1.5 million, with a $750k earnout if the business does $750k in the year following the sale.
When It’s Warranted
An earnout is traditionally part of an offer when there is risk to the buyer that the future may not be the same as the past. This could be due to the possibility of customers and/or key employees leaving, global market changes, new products coming online, or new offices opening. An earnout can be both good or bad, giving shared risk between the buyer and seller where both parties benefit or fail together.
When your business is stable, consistent, and has strong management in a reliable market, the offer typically does not include an earnout. All business sales have risk, but the earnout places that risk on a percentage of the sale price, mainly to protect the buyer.
Risks to the Seller
An earnout sounds like a great advantage to have if you’re the seller and want to get more money for the business, but it’s not always a no-brainer. The clear and present danger is that you have no control over how the buyer runs the business after the sale. They could completely crash it, for all you know.
The metric to which the earnout is attached can also present problems. Typically, you want an earnout to be based on gross sales or gross margin because gross figures can be adjusted the least, whereas net figures involve many business decisions. Net profit is particularly volatile; your business can triple in revenue under its new owner, but if they’re burning through dollars to get there and the margin is slim, your earnout is lost. You can see how earnouts sometimes lead to disputes if there are suspected illegitimate expenses run through the business, financials manipulated, or questionable decisions made.
Rule of Thumb
The only time we recommend seeking an earnout is when you’re completely comfortable with the guaranteed sale price. The earnout would be nice to have, but not a deal-breaker.
This is just one of the many terms in a business sale agreement that could work to your advantage or disadvantage. See how Exit Consulting Group helps owners explore and prepare for a successful sale with reliable business brokering.