There are countless ways to structure a business transaction, and while this can be good, it also adds to the complexity of the process. Because you can slice and dice the deal any which way, it can be difficult to identify exactly which way is right for you.
This can be particularly true when it comes to agreeing on the proper price for your business. Not surprisingly, sellers tend to think their business is valued at a higher price than what a buyer may believe.
In situations where there is a gap in the perceived valuation of a business, an earnout may be a good way to bridge that gap in price.
What is an Earnout?
No matter how you choose to define the terms of a business sale, there will be risks for both parties. An earnout is no different. It also comes with risk, but there are situations when this risk may make good business sense if you are willing to bet on the future performance of your company.
By definition, an earnout is a contractual provision in which the buyer agrees to pay the seller additional money if the business achieves certain performance metrics after the close of the sale.
For example, if a seller wanted to sell their business for $10 million, but a buyer thought it was only worth $8 million, they could structure the sale so that the initial paid price is $8 million, and the difference of $2 million would be paid as an earnout.
The term of an earnout is typically 1-3 years in length and valued at a percentage of the purchase price. Earnouts are tied to performance and will only be paid if those future targets are met (hint: to avoid an all-or-nothing situation, be sure to specify in your contract that the terms be based on a graduated scale).
When to Consider Using an Earnout
There are a few common scenarios when a seller might consider an earnout:
- You feel comfortable betting on the future performance of your business.
- You want to remain involved in the business even after the sale.
- You believe your business has unrealized potential and is well-positioned for continued growth and success.
As an added benefit to the seller, financing that is spread out over the course of a few years may minimize the tax impact tied to capital gains.
Buyers can also benefit from an earnout because they too can spread out their payments. Moreover, if the business does not perform well, the buyer isn’t responsible for paying as much.
Considering an Earnout? Talk to Us First.
When structuring the sale of your business, it’s important to have the very best team on your side and receive legal advice tailored for your specific situation.
Our commercial law team at Silverberg|Brito, PLLC has your back. Get in touch with us to schedule a free consultation.