What is an earnout agreement?

In mergers and acquisitions, earnout agreements are becoming more and more popular. 

They are contracts where the buyer pays part of the price later, depending on how well the business does. These agreements can be beneficial for both buyers and sellers, but if they are not set up right, they can cause problems. 

What is an earnout agreement?

A contractual agreement between a buyer and seller where part of the price depends on how well the business performs after it is bought. This payment usually relies on meeting certain goals, like financial or operational targets, for a set amount of time. The Earnout amount within agreements can vary, like being a fixed amount, a percentage of the price, or calculated using specific measures.

Benefits of earnout agreements

Earnout agreements offer both buyers and sellers benefits. 

For buyers – they help reduce the risk of paying too much for an acquisition and make sure both parties are working towards the same goals. By creating a correlation between price and performance of the acquired business’s performance, buyers can be confident they are paying a fair amount, and sellers are encouraged to support the business after the sale. 

For sellers – earnouts let them get more value from their business and share in its success. If the business does well, sellers can receive a higher price than they would have otherwise.

Drawbacks of earnout agreements

Earnout agreements also have downsides for both buyers and sellers. 

For buyers – they can bring uncertainty and complexity to the acquisition process. Negotiating earnout terms with sellers can be time-consuming and may lead to disagreements. Administering and measuring earnouts can be tricky, with disputes arising over how to interpret the formula or meet performance targets.

For Sellers –  face risks and uncertainties with earnouts too. If the business underperforms, they might get less money than expected. Moreover, buyers might try to manipulate earnouts, causing disputes and further complications.

Best practices for structuring earnout agreements

To ensure smooth earnout agreements, buyers and sellers should follow these best practices: