Earnout - Example

Example

The buyer pays $10m for 100% of the share capital of the target Company in cash at the closing of the transaction. He also agrees that he will pay an additional $10m over the next 3 years if and only if the Company achieves certain profit targets for the next 3 years.

So it means, if the Company underperforms and fails to achieve the forecast profit targets, the buyer will have paid only $10m. On the other hand, if the Company grows and achieves fully the pre-agreed profit targets, the buyer pays an additional $10m, (for a total of $20m).

It is used to describe the payment to shareholders selling their shares in a company where the payment is contingent on the achievement of certain performance criteria (e.g. company profits) over a specified period after the closing of the sale.

It is often used when small companies in high-growth, high-tech or service industries are sold. The acquirer typically pays 60–80% of the purchase price up front with the remaining 20–40% structured as an earn-out and paid out over time as the acquired company achieves certain levels of sales or profitability.

The purpose of an earn-out is to bridge valuation gaps. For example, if the seller of a business expects a higher price, the buyer can suggest an earn-out (contingent on future earnings) to reduce the risk while committing to a higher price. Risk is reduced because part of the purchase price is contingent upon good performance. While this appears that the buyer is in effect paying more for the business, technically if they pay the full price, they're doing so for a company with greater earnings than at current. Also, the delay of the payment (sometimes as much as five years) reduces the value of the contingent payment due to the effect of time on money. Keeping this in mind, the buyer appears to be paying more for the business, but in real terms it could be much less. Another purpose the earn-out serves is the motivation of the management in place during the earn-out period to achieve good performance. This is especially important in companies that are highly dependent on few key people.

The term is not used by private equity and venture capital investors only, but used also by strategic buyers.

Other financial motivators for top management teams to achieve targets are sweat equity, or management options. Private equity investors religiously use strong financial motivations for the top management teams into which they invested.