Only after weeks of negotiations do the buyer and seller of a business usually agree on the definition of a “fair” price for that asset. Even then, the seller often expects substantial growth of the business after the sale, and the buyer wants to give the seller a financial incentive to remain focused on growing the business after the change in ownership.

To address this issue, the buyer and seller frequently agree to set aside a portion of the purchase price to be paid long after closing — but only if the business achieves certain milestones. This contingent payment is known as an earnout.

Buyers typically value businesses based largely on past performance; sellers usually prefer to value them based not only on past performance, but also on projected growth. An earnout provides a mechanism to tie a portion of the purchase price to future performance. In deals with an earnout, the seller gets the opportunity to be paid on future cash flows while the buyer doesn’t have to pay that additional consideration unless and until the acquired business meets specific performance objectives.

Industry data suggests that about half of all business acquisitions by private equity firms involve an earnout; many acquisitions by strategic buyers also include that feature. Earnouts typically last from one to five years, and account for 15% to 30% of the purchase price. They are particularly common in acquisitions of high-growth companies and businesses in which the former owner’s relationships with clients are crucial.

When considering an earnout, it is wise to follow a few broad guidelines:

Keep It Simple
Earnouts are effective as an incentive for the seller when the payout is based on one or two simple variables. They can be financial (revenue, gross margin, pre-tax income, etc.) or operational (customer retention, productively, unit growth, etc.). Simplicity provides clear objectives and less room for argument when it comes time to pay the earnout.

Maintain Control
Sellers need to be sure they can directly influence or control the earnout’s selected metrics. Top-line targets such as revenue and gross profit are often preferable to earnings targets that can be affected by the buyer’s allocation of expenses to the operating unit in question.

Keep It Short
In most cases, the longer the earnout period, the more risks the seller assumes. Those risks include unforeseen changes in the economy and the marketplace, and in the buyer’s business strategy as it relates to the acquisition.

Align the Goals
The achievement of the earnout should be a welcome development to both the buyer and the seller. The seller will receive a higher value for his company, while the buyer will benefit from the strong performance of its acquisition.

Be Careful About Taxes
The structure of an earnout should delay any tax liability until the time the earnout is actually earned. Careful attention, and input from accounting and legal advisors, is critical to successful tax planning of contingent considerations.

Structure is as Important as Valuation
Buyers are often willing to assign higher valuation levels to future revenue or earnings targets than to trailing 12-month financial figures. They also tend to be generous with non-cash future payments. Sellers should be cautious about accepting an unusually low valuation at closing, while counting on “maxing out” their earnout in order to achieve their desired total valuation for the transaction. They should also have a healthy level of skepticism about the putative value of current and future non-liquid, non-cash payments.

Acknowledgment

The inspiration for this topic was a similar commentary written by my Fairmount Partners colleague Andy Greenberg in the most recent edition of his Middle Market Monitor newsletter. Let me once again remind the readers that I will be happy to consider their suggestions for a topic to discuss in a future column.

Michael A. Martorelli is a Director at the investment banking firm Fairmount Partners. For additional commentary on the topics covered in this column, please contact him at [email protected], or at Tel: (610) 260-6232; Fax (610) 260-6285.