Loading the player...

What is an 'Earnout'

An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings. If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1,000,000 plus 5% of gross sales over the next three years.

BREAKING DOWN 'Earnout'

Earnouts do not come with hard and fast rules; instead, the payout's level is dependent on a number of factors, including the size of the business. This can be used to bridge the gap between differing expectations from the buyers and sellers. The earnout helps eliminate uncertainty for the buyer as it is tied to future financial performance. The seller also receives the benefits of future growth for a period of time.

Key Issues

There are a number of key considerations, aside from the cash compensation. This includes determining the crucial members of the organization and whether an earnout is extended to them. The length of the contract and the executive's role with the company post-acquisition are two issues that also have to be negotiated.

The agreement should specify the accounting assumptions that will be used going forward. Although a company can adhere to generally accepted accounting principles (GAAP), there are still judgments managers have to make that can affect results. For instance, assuming a higher level for returns and allowances will lower earnings.

A change in strategy, such as a decision to exit a business or invest in growth initiatives may depress current results. The seller should be aware of this in order to come up with an equitable solution.

There are legal and financial advisors that can assist with the process. The fee typically grows with the complexity of the transaction.

A Hypothetical Example

ABC Company has $500 million in sales and $50 million in earnings. A potential buyer is willing to pay $250 million, but the current owner believes this undervalues the future growth prospects and asks for $500 million. To bridge the gap, the two parties can use an earnout. A compromise might be to an upfront cash payment of $250 million and an earnout of $250 million if sales and earnings reach $1 billion within a three-year window or $100 million if sales only reach $600 million.

RELATED TERMS
  1. Seller Financing

    Seller financing refers to a real estate agreement where financing ...
  2. Purchase-Money Mortgage

    A purchase-money mortgage is a mortgage issued to the borrower ...
  3. Buyer's Market

    A situation in which supply exceeds demand, giving purchasers ...
  4. Buyers/Sellers On Balance

    1. A ratio based on aggregate market orders for securities that ...
  5. Exchange Ratio

    The relative number of new shares that will be given to existing ...
  6. Carriage Paid To (CPT)

    Carriage Paid To (CPT) is an international trade term denoting ...
Related Articles
  1. Investing

    The Ins And Outs of Seller-Financed Real Estate Deals

    There's more than one way to buy or sell a house. Seller financing presents yet another unique option.
  2. Investing

    4 Ways Millennials Can Buy Private Businesses

    Buying private businesses is a good way to have greater control over your investments while increasing your income and avoiding the fluctuations of the market.
  3. Small Business

    7 steps to selling your small business

    Selling your small business is often a complex venture. These seven considerations can help you build a solid plan for profit and lead to success.
  4. Investing

    Home Sale Contingencies: What Buyers And Sellers Need to Know

    Home sale contingencies protect buyers who want to sell one home before purchasing another. Find out what buyers and sellers need to know about these contractual conditions.
  5. Investing

    10 Must-Know Questions To Ask A Home Seller

    To get a sense of what the home you're considering buying is really like, it helps to talk to the seller.
  6. Investing

    Rent-to-Own Homes: How the Process Works

    A rent-to-own agreement, also called a lease option or lease-to-own agreement, offers an alternative way to buy a home.
  7. Investing

    Playing hardball when selling your home

    Are you planning on selling your house? Learn these strategies to help you get you a better deal in house sale.
  8. Managing Wealth

    Rent-to-own homes: How the process works

    Here's what to watch for when negotiating a contract for a rent-to-own home – and who is a good candidate for this option.
  9. Small Business

    The Buy Side of the M&A Process

    Mergers and acquisitions can anywhere from months to years, depending on the complexity of the deal and the companies involved.
  10. Investing

    8 reasons to sell your home with an agent

    The standard real estate agent cost you 6% of the total house sales, learn what value do they bring you. See if it is worth to hire a sales agent in a housing sales.
RELATED FAQS
  1. What are the key factors that cause the market to go up and down?

    Learn how factors like wars, inflation, government policy, technological change, corporate performance and interest rates ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center