What Is an Earnout? Advantages and Disadvantages of Use

Updated December 12, 2022

The sale of a business can be a complex process involving negotiation, price agreements and the exchange of large amounts of money. One way buyers finance the purchase of a company is through an earnout. Understanding how earnouts work can be helpful when participating in the sale of a business.

In this article, we describe what earnouts are and how they work, plus the benefits and drawbacks of using earnouts to support business transactions.

Key takeaways:

Earnouts provide a way for companies to fund the purchase of a business, such as in an acquisition or merger.
One of the biggest benefits of an earnout is that it gives businesses a longer period to finance corporate purchases.
Earnouts may not be a solution for every organization, though, so it’s important to assess financial needs and operational goals to determine the most appropriate means of financing business transactions.

What are earnouts?

Earnouts are payments a seller receives from the buyer of their business only if the company reaches agreed-upon performance goals. The buyer pays a portion of the company's value upfront and provides the seller with additional compensation depending on the company's future success. Earnouts can be a common provision during an acquisition or merger where one company acquires another.

How do earnouts work?

Buyers and sellers typically determine earnout payments based on the company's sales or earnings. The seller usually receives a percentage of sales or earnings if the business exceeds certain margins. For example, an owner might sell their company for $750,000 million, plus 4% of sales over the next five years. Buyers and sellers might also create an earnout agreement when:

The buyer can't afford to pay the company's full value upfront.
The buyer and seller can't agree on a price.
The company encourages employees to remain with it after its buyout.
A startup currently has a low market value but has significant future earning potential.

Essentially, the seller finances the buyer's purchase of the business. As the acquired business continues to generate profits, the more money the seller potentially earns. This in turn enables the buyer to pay off the purchase more quickly.

Advantages of earnouts

Earnouts can benefit both the buyer and seller of a company. Here are several benefits for companies using earnouts to finance their purchases:

Higher confidence: The buyer has less uncertainty about their investment because the total amount they pay depends on the company's performance. If the business is not as successful as they anticipated, they pay a lower total amount for it.
More time to pay: Buyers have a longer time to pay for the company's purchase, which is often easier on them financially.
Smaller upfront payment: The initial purchase price is often more manageable for the buyer than paying for the company's full market value.
Continuous income: The seller receives earnout payments for a period, providing them with an additional source of earnings.
Lower tax payments: Since the company's sale is spread over several years, the amount of taxes the seller owes on it is spread out as well.
Performance incentives: Because the buyer benefits from the company's success, they have an incentive to keep the company reputable and performing well.

Disadvantages of earnouts

Earnouts can have some drawbacks, depending on the company's performance and the details of the contract. For instance, the seller may continue to have a financial interest in the business and give input or direction. For this reason, companies often include a specification that eliminates the seller’s involvement after a certain period.

In addition, some companies may have lower profit expectations, resulting in lower payments to the seller over a longer period. Many earnout agreements, therefore, include conditions that protect the buyer from bankruptcy if this scenario occurs.

What do earnout agreements outline?

Earnout agreements can also include complex details that provide in-depth outlines of each term and condition. The agreement should be clear so all involved parties understand what the transaction requires. If you’re overseeing the creation and documentation of an earnout agreement, several core elements to consider include:

Contract length
Financial metrics for measuring performance
Accounting principles for tracking earnings
Staff and departmental roles in the company after the sale
Earnings distribution and payouts

Earnout examples

Ultimately, an earnout agreement is a custom document detailing specifications that are unique to each business. When companies create these agreements, they often outline parameters that align with revenue goals, current cash flow and long-term ability to pay down debts. Here are two examples of possible earnout agreements:

Example 1

A company has $70 million in sales and $8 million in earnings. A buyer offers $300 million for the company, but the seller believes the company is worth $500 million. Selling it for less than that amount might undervalue its growth prospects.

To solve this challenge, both parties compromise by agreeing to an earnout that allows the buyer to pay $300 million upfront, plus an additional $200 million if sales exceed $100 million within four years. If sales do not reach that amount within four years, the buyer only pays an additional $100 million. If sales are below $70 million within four years, the buyer does not pay an earnout.

Example 2

A seller prices their company at $75 million, but an interested buyer can only pay $50 million. With a fair market value of $75 million, the seller offers to finance the remaining amount of money. In this case, the seller is essentially loaning the buyer $25 million, which the buyer agrees to pay back over a certain period. This period is then based on the company's earnings.

To determine the length of time of the earnout, the seller sets a minimum earnings percentage for each year of a five-year "loan." In year one, the buyer pays a minimum of 15% of earnings before interest, taxes, depreciation and amortization (EBITDA), which can be no less than $5 million. In year two, the buyer pays a minimum of 15% EBITDA, which can be no less than $10 million. The minimum increases each year until the buyer has paid for the company in full.