Payment Terms: Earnouts

April 13, 2006

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Where there is disagreement about how much the company is worth, it's fairly common to include an "earnout" as one of the terms of the deal.

An earnout is a contractual arrangement in which the purchase price is stated in terms of a minimum, but you (the seller) will be entitled to more money if the business reaches certain financial goals in the future. These goals should be stated in terms of percentages of gross sales or revenues, rather than net sales, because expenses are easy to manipulate and thus net sales are too easily distorted.

A simplified example of an earnout provision would be one stating that the seller is entitled to 1 percent of all gross sales between 1 and 2 million dollars, and 2 percent of all sales over 2 million, payable annually for the first three years after the sale.

If you do use an earnout, it's important to state in the contract exactly who will be reviewing the books and verifying the business's performance. From the seller's perspective, you should be more likely to agree to an earnout if you'll maintain an employment or consulting relationship with the buyer. That way, you'll be able to keep an eye on things to make sure the buyer is taking all steps necessary to reach the goals, is not making unrecorded sales for cash, keeping two sets of books, etc.

From the buyer's perspective, an earnout is a good solution to uncertainty about the business's future since the payments can often be internally financed. The buyer will want to place a cap on the total earnout payments to limit the risks. Particularly if the seller remains active with the business, the buyer will want to be sure the seller isn't making lots of sales that will never be collected on or that will hurt the business's profit margin.