An Earnout is a contractual provision stipulating that the seller of a company will receive additional remuneration in the future if the company achieves certain financial goals, usually expressed as a percentage of turnover or gross profit. The agreement should also define the accounting assumptions that will be used in the future. While a company can comply with generally accepted accounting standards (GAAP), judgments still need to be made to executives that may impact results. For example, assuming a higher level of returns and value adjustments will reduce returns. There are a number of important considerations, with the exception of cash compensation when structuring an earnout. This includes designating the key members of the organization and including a earnout. The financial metrics used to determine the earnout must also be defined. Some metrics benefit the buyer, while others benefit the seller. It`s a good idea to use a combination of metrics like revenue and profitability metrics.
ABC Company has $50 million in revenue and $5 million in profit. A potential buyer is willing to pay $250 million, but the current owner thinks this underestimates future growth prospects and asks for $US 500 million. To fill this gap, both parties can use an Earnout. A compromise could be a $250 million down payment and a $250 million earnout if revenue and profit reach $100 million in a three-year window, or $100 million if revenue reaches only $70 million. For the buyer, the advantage is to have a longer period to pay for the deal, rather than everything in advance. If the gain is not as high as expected, the buyer does not have to pay as much. For the seller, the advantage lies in the possibility of spreading the taxes over a few years in order to reduce the tax impact of the sale. An Earnout helps to remove uncertainties for the buyer, as it is linked to future financial performance.
The buyer pays part of the company`s costs in advance, and the rest of the costs depend on the achievement of future performance targets. The seller also receives the benefits of future growth for a certain period of time. Different financial goals such as net profit or revenue can help determine earnouts. If an entrepreneur who wants to sell a business demands a higher price than a buyer is willing to pay, an Earnout provision can be used. In a simplified example, there could be a purchase price of US$1 million plus 5% of gross revenue over the next three years. One of the disadvantages for the buyer is that the seller can be involved in the business for a long time, want to help increase revenue or take advantage of their past experience to manage the business as they see fit. The downside for the seller is that future revenue isn`t high enough, so they don`t do much of selling the business. Earnouts don`t have strict and fast rules.
Instead, the payment amount depends on a number of factors, including the size of the business. This will bridge the gap between the different expectations of buyers and sellers. The duration of the contract and the role of the manager with the company after the acquisition are two subjects that must also be negotiated. This is due to the fact that the company`s performance is linked to both management and other key agents. If these employees leave, the company cannot meet its financial goals. A change in strategy, for example. B the decision to leave a company or invest in growth initiatives can hurt current results. The seller must be aware of this in order to find a fair solution.. .