What is Earnout?

Often this earnout payment is used to bridge the valuation gap. If a person who is selling the business is asking more price than what is asked by the buyer, then, in that case, such a provision is helpful. The seller gets paid only if the predetermined future level of EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business’s performance with that of its competitors.read more or financial targets is achieved as decided by the parties concerned.

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Examples of the Earnout Payments

Example #1

X Ltd is running a textile business in which during the last financial year, sales were $ 400 million, and the earnings were $ 100 million. A person, Mr. Y, 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.

To reach 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. If these targets are not met, the seller will not be paid anything in the future.

 So the owner asked for the $ 400 million as the price for his business, which Mr. Y denied agreeing.

It is an example where the two parties made a financial agreement. One party decided to sell the business to the other party because some money will be paid upfront and some if a predetermined future earning level is achieved. It helped bridge the gap between the buyer and the seller of the business.

Example #2

X is the owner of the business 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 a 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 if the business under the new buyer achieves EBITDA of $ 25 million per year.

Advantages

  • Earnout helps eliminate uncertainty for buyers as they 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 payout level depends on several 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.

Disadvantages

  • 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 alignment of incentives among the concerned parties, consideration of proper milestones, etc.IIt requires the careful drafting of everything, including definitions and covenantsCovenantsCovenant 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.read more. All the terms and conditions have to be drafted properly, as even a single confusion can cause problems among the parties in the future.

Important points of the Earnout

  • It is a contractual provision that the seller of a business will obtain future compensation if the business achieves certain predetermined financial goalsFinancial GoalsFinancial goals are targets set by an individual to achieve financial milestones or plans. In other words, they are financial objectives that an individual wishes to accomplish within a certain time frame.read more.These payments help eliminate uncertainty for the buyer. 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.

Conclusion

Thus, the Earnout provides the opportunity to the seller and the buyer to decide the mutual price for the financial transaction and bridge 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 payout level depends on several 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 –

  • Bridge FinancingHow to Get Into Venture Capital?Carried InterestPrivate Equity MeaningTop 10 Best Mergers and Acquisitions (M&A) Books