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Posted on January 27, 2016 @ 09:28:00 AM by Paul Meagher
If you are selling your business (or some percentage of it) and you think it is worth $X but your buyer thinks it is worth $X-$diff, then you might still reach an agreement if you agree to the $X-$diff valuation today and the seller agrees to an "earnout" for the remaining $diff if the company performs to a certain standard over an agreed upon time frame. You as the seller get an immediate payoff less than your valuation, but you earn the rest of your valuation if your company performs as well or better than it has in the past.
An earnout seems to be a clever way to potentially reach an agreement between the buyer and seller of a business when there is a valuation disagreement. There are hazards, however, to cutting such deals. Mark Mcleod came out strongly against them arguing that earnouts almost never work
due to alignment issues they can cause between the buyer (who doesn't want to pay the earnout) and seller (who wants the earnout). Mark suggests you treat an earnout provision like a lottery ticket with no strong expections that you will receive it.
Two other issues with earnouts have to do with potential litigation and negative tax consequences. Litigation often arises because there is a dispute as to whether the relevant earnout milestones were achieved and the seller may object that they were blocked in some way from achieving their earnout targets because of the buyers actions. One also has to consider whether the money paid as earnout money is treated the same as the capital gains arising from selling your business or part of
it. Often earnout money is subject to higher taxes. These issues are discussed in more detail in lawyer Roger Royse's article The Problem with Earnouts.
So while earnouts would appear to be a clever bargaining technique in arriving at an agreement between a buyer and seller of a business, there are some negative consequences that all parties should be aware of and make allowances for if they still want to use an earnout to resolve valuation disagreements.
The purpose of this blog was to raise awareness of the concept of an earnout and some of the concerns that cause bloggers and lawyers to often speak poorly of this bargaining technique.