With a prideful twinkle in their eye, owners often set the asking price for their business fully confident it will shower the buyer with riches for years to come. The problem? Buyers don’t always share this rosy optimism, preferring instead to make offers based on past performance.
This is where earnout agreements come in. They help sellers and buyers bridge the gaps in price expectations that can quickly derail a transaction.
Simply put, earnout agreements allow sellers to receive additional revenue from the buyer after closing if the company hits certain targets, usually within one to four years. Meanwhile, buyers who are worried about overpaying use earnouts to mitigate their risks. Earnouts are especially popular during times of economic uncertainty, such as the one we’re in now, as all parties are seeking more security.
Earnout agreements have a lot of moving parts, so we want to provide a quick overview of the key considerations and potential pitfalls. The more you know, the better choices you can make.
Treat Any Earnout As a Bonus
If you take away only one gem of wisdom from this post, this is it: Earnouts should be icing on the cake, or gravy, or whatever topping you prefer. You need to feel good about the cash you collect at closing with the assumption that you may not see anymore. If you are relying on earnout revenue to fund your lifestyle, don’t make the deal.
Have Realistic Expectations
We see lots of buyers set themselves up for disappointment by using overly optimistic projections to determine earnout amounts. It’s in your best interest as a seller to make projections as realistic as possible, especially for the first year after the transaction, which tends to be a bumpy one.
Alternatively, given the uncertainties we’re facing due to COVID-19, you may want to explore deferring the start of the earnout period for a year to see if the situation settles down. This option could also result in significant tax benefits by delaying recognition of the deal.
A good earnout agreement spells out everything to the letter. That means stipulating which accounting standard will measure your chosen performance indicator, milestone reporting dates, and the amount of time you’ll have to review and respond to the buyer’s calculations. We recommend including a sample calculation with illustrations so there’s zero room for misunderstanding.
On a related note, sellers benefit most when they base earnouts on those items further up the income statement. Targeting sales instead of net income, for example, makes calculations easier and reduces opportunities for manipulating numbers.
Hope for the Best, But…
You know the rest. Despite everyone’s best efforts and intentions, disputes happen. Build mechanisms into your earnout for settling any disagreements. Preferably, you’ll opt for mediation rather than arbitration and courts. Make it clear which third-party accounting or law firm will help with the forensics.
Keep open lines of communication with your buyer. Establish timeframes for reporting and remain transparent with information. When you receive reporting from your buyer, review all the computations carefully to make sure they match what you established in your agreement. You will also need to make sure you are following any timelines established in the purchase agreement.
Build an Earnout Dream Team
This one’s a must. Earnout agreements get complicated. Bring in a well-respected transaction attorney and experienced accounting consultants to support you. The trusted advisors at Sikich have structured and assisted with many earnout agreements. We’ll help you establish a deal that works with your goals and includes realistic recommendations for duration and computations. Along with your attorney, we’ll help you get the wording right and make sure you cover all the bases, including any tax implications.
To learn more about keeping your transaction on track and maximizing the returns of an earnout agreement, reach out to the Sikich team today.