What is an Earnout in Simple Terms?

An earnout in simple terms is best described if you imagine you are looking to buy a business that’s selling cookies, and you agree to buy this cookie-making business.

An earnout is when you buy a business, where part of the acquisition price is deferred and contingent on future sales or profits. The amount of the earnout will reflect the business’s performance, with any additional payment due tied to its success post-acquisition.

But instead of paying all the money for the cookie business right away, you decide to pay some of the money later, based on how many cookies are sold, after buying the business.

The extra money you pay later, which is based on how well the business does, is called an earnout. So, it’s like a bonus the seller makes (or earns) after they’ve sold their business, depending on how well it keeps doing.

Earnouts are often created when the buyer and the seller can’t agree on the price or valuation for the business.

For example; “if the seller thinks the business is worth £1 million and you believe it’s worth £750,000, you could agree on an initial price of £750,000, and the difference between you and the seller of £250,000, can form part of the earnout.

The additional £250,000 should be made contingent, or in other words only payable, if certain milestones are reached.”

For example, sales or profits should hit an agreed target within an agreed timeframe. So, in other words, it’s a way of bridging the gap between you and the seller in order to make the deal happen.

Why the seller of a business would want an earnout

I sold one of my businesses with an earnout clause, which meant that if the business’s revenues (or sales) hit certain levels, the buyer would pay more for the business.

The reason I wanted an earnout included in the sale and purchase agreement, was because it wasn’t easy to predict the revenue streams from my clients, so it was agreed between us to adjust for this uncertainty by having an earnout clause in the agreement.

The buyer agreed to pay an extra bonus amount, if the revenues from the clients hit certain levels, within an agreed period after the sale date.

But what would happen if the business’s revenues fell short of sales, below which the bonus would not have been payable in the first place?

Or in other words, how do you protect the downside? I answer this question in the following post; “What is the downside of earnouts? And how you protect yourself?”

Are earnouts a good idea?

One reason why I’m not keen on buying a business with an earnout, is because the bonus is based on your hard work once you own the business, and not that of the seller.

But having said that, having an earnout as part of the sale and purchase agreement will mean the seller will be actively interested in the business doing well, after they’ve sold it to you, and they will be more willing to provide support and help, post sale.

If you are struggling to agree on price or business valuation with the seller, using an earnout is one way in which you can still achieve a win-win outcome, instead of you walking away from the deal. But I do recommend you read my post on how to protect yourself from the downside too.

If you have any questions on this topic about buying a business, or on any other aspect about the process involved in buying a business, please drop a comment below.

And always remember that no question is a stupid question, if you don’t know it, you don’t know it, and by having the answer to a question you have, might be all it takes to move to the very next step in your journey to buy a business.