When it comes to buying or selling a business, there are a variety of different ways to structure the transaction. One potential option is to use an “earnout” which is a side agreement (separate from the purchase agreement) that allows the seller to receive additional compensation in the future based on the post-closing performance of the business.
An earnout typically works by setting a target for the business’s future performance, such as a certain level of sales revenue or profit. If the business meets or exceeds this target, the seller then receive additional compensation on top of the initial purchase price. However, if the business falls short of the target, the seller may not receive this additional compensation.
There are a few potential benefits to using an earnout in a business purchase. First and foremost, it can help to bridge any gaps in valuation between the buyer and seller. If the buyer is hesitant to pay the full asking price for the business, an earnout can provide a way to make up the difference by tying additional compensation to the business’s future success.
Additionally, an earnout can provide an added incentive for the seller to work with the buyer to ensure the business’s continued success. If the seller has a stake in the business’s future performance, they may be more likely to stay involved and help the buyer navigate any challenges that arise.
That said, there are also potential downsides to using an earnout. For one, it can be difficult to accurately predict future business performance, which means there is some risk that the seller may not receive any additional compensation despite their efforts to ensure the business’s success. Additionally, strictly defining the earnout amount (and its later calculation) can add additional complexity to the negotiation and drafting of the transaction, which may make it more difficult to negotiate and finalize the deal.
Despite these potential downsides, however, earnouts are still useful tools in certain business purchase transactions. They can help to align the interests of the buyer and seller, provide a way to bridge valuation gaps, and incentivize ongoing collaboration and support. As with any business transaction, it is important to work with your legal and accounting professionals to carefully consider the potential risks and benefits before deciding whether or not to include an earnout in your purchase agreement.
As always, if you have any questions about buying or selling a business, or business law generally, please don’t hesitate to contact us!