Understanding Earnout Agreements
Anyone with an interest in the sale, acquisition, or merger of a business might be faced with the prospect of entering into an Earnout Agreement. In a business merger and acquisition environment, an Earnout Agreement enables buyers and sellers to assign a variable value to part of the sale price and tie it to the business’ post-sale performance.
Making The Deal
As part of a sale contract, a formal Earnout Agreement can help a deal move forward when buyer and seller have trouble agreeing on a price. By making part of the sales price dependent upon future performance, an Earnout Agreement reduces risk for buyers and incentives sellers to retain interest in business performance until long after the sale is completed. If done well, it can reduce risk for all parties, ensure an equitable sale price, and help a deal move forward.
A Unique Contract
Every agreement is a unique contract negotiated as part of its own sale, but generally speaking, an Earnout Agreement simply ties purchase price to actual performance. Rather than completing the sale as a single transaction and conveying the entire purchase price from buyer to seller when ownership changes, the parties exchange a specified sum at closing with additional payments to be made later when (and if) specific business performance goals are met.
The parties to a sale may be interested in pursuing an Earnout Agreement for a variety of reasons, but in general, it is a way to bridge differing opinions about company value.
If the buyer simply doesn’t trust the accuracy of the company’s projected growth or profitability, an Earnout Agreement can allow them to hedge their total sale price by making part of the sale price contingent upon meeting those goals. It may also provide a negotiating tactic that tempts an overly-optimistic seller to chase a larger payment later (which may or may not happen), and accept a lower guaranteed payment now. For cash-challenged buyers, an Earnout Agreement may also offer a way to complete an acquisition now, while deferring part of the payment until later.
A seller might pursue an Earnout Agreement as a way to sweeten a deal with bonus incentives later. They may also view it as a way to extract a higher total sale price than the buyer is willing to offer. Sellers may pursue this kind of arrangement because they are confident in the future performance of their company, or they may just want to retain a stake in future profits, should that big growth spike come. Savvy sellers might also look at the deferred income from an Earnout Agreement as a means to receive tax benefits by stretching the purchase price across multiple tax years.
Both parties have a vested interest in negotiating an agreement with well-defined terms, clear objectives, and a solid legal structure. As with any contract, an Earnout Agreement can become a source of disagreement if not set up properly and should be structured and entered into carefully by all interested parties.
Is It For You?
If you are interested in setting up an Earnout Agreement for the sale or acquisition of a business, Maxwell Dunn can advise you from first discussion through signed agreement. Our attorneys have deep experience with M&As and can craft an agreement that will work for your company. Contact us today to set up a consultation with our knowledgeable business and bankruptcy attorneys.