In M&A deals, it is a common misperception that earnouts are valuable only to the acquirer. But if done right, earnouts can be win-wins for both buyers and sellers.
Sellers are turning to performance-based earnouts to bridge the gap between seller and buyer expectations, and get the seller closer to today’s high multiple valuations. Earnouts can also be a strategic option if the seller’s performance has been inconsistent the last few years but they still believe their business is worth a decent multiple.
Consider this example, in which the seller’s business has averaged $250k in EBITDA the last three years, with a high of $500k and a recent year at almost break even. The seller believes they can get back to the $500k and even higher due to synergies from the combined company. The buyer believes this too but has concerns about the recent year at break even.
Here is how an earnout structure could work:
In this example, a multiple of upfront consideration would be negotiated, with some of it in a promissory note and some of it in cash for the seller’s sweat equity. Let’s say the seller can get 2-3x the three-year average of $250k in upfront money. So what about the rest?
An earnout threshold of $250k could be negotiated that the buyer would keep. Then they would negotiate a split above the threshold.
Let’s say, in this case, it is a 50/50 split above threshold up to 5x the three-year average of $250k, or $1.25 million in the aggregate. I have seen the split above the threshold negotiated differently and even change from year to year.
In this example, the seller is able to get some money for their sweat equity and achieve a fair valuation for the business in three years if the business performs as they all believe it can. It might take a little longer but they can still get there.
It’s worth noting that sometimes there is no cap on the earnout from the buyer, therefore providing more upside. In many cases the term of the earnout is three years. I have put together deals for four to five years and even extended the earnout term because the combined companies performed so well.
A sophisticated buyer knows that an earnout is a win-win and is not concerned with paying out more money in the aggregate giving the seller a higher multiple.
Get more information on why to pursue an earnout
If you’re a seller and looking to stay on with the combined company after the deal, the earnout is a great way to enhance the valuation of the business and even recognize some upside. A quality M&A consultant can help structure a win-win for both sides, while ensuring you, as the seller, get maximum value.
Steve Pomeroy is the founder of Big Change Advisors, a unique M&A consulting firm in Los Angeles that helps businesses achieve big goals while making a big impact on society. To request a free consultation, contact us.