Valuing a for-sale opportunity becomes more challenging during periods of economic and financing uncertainty.
During an economic boom, sellers are often able to obtain top dollar due to increased competition among buyers, with readily available financing options.
However, in today’s market, buyers are more cautious about the businesses they are buying and the amount they are willing to pay. Despite a challenging economic market, most sellers have not adjusted their expectations regarding the value of their businesses. Such misperceptions make negotiating a purchase price much more difficult.
An earnout provides a way to bridge the seller/buyer gap with contingent payments that mitigate risk for buyer and creates incentives for sellers/ management. For example, the targets can be based on meeting certain revenue goals or the development of a product. While not new, earnouts are more frequently used during economic downturns and with small, private company acquisitions.
Earnouts are challenging instruments to structure. Since earnouts can result in litigation among the parties, it is vital that the buyer and seller carefully consider the conditions under which future earnout payments will be made.
Since an earnout is based on future financial performance, both parties should be clear about the method for calculating the performance targets (including accounting methods), how much control over the operations of the business the seller retains during the earnout period (including the amount of capital available to fund the business, who has the ability to hire and fire employees, and how strategic business decisions are made), and seller’s remedies (such as a fixed dollar amount of damages) if the buyer breaches its obligations under the earnout.
While earnouts are not appropriate for all transactions and can be complicated and time consuming to negotiate, earnouts provide an additional tool to consider as either a buyer or seller – particularly in an uncertain and challenging economy.