What Is The Downside of an Earnout?

One of the main drawbacks of an earn-out payment is the uncertainty involved. This is because the bonus payment (or earn out amount), is dependent upon the future performance of the business.

To protect yourself from an earnout, include a clawback clause such that if sales or profits fall short post-acquisition, the seller must repay part of the sales price. Also, by funding the acquisition using seller financing, any clawback can be deducted from seller financing payments.

Which means, there’s are no guarantees that the seller will receive the additional payments they are hoping for.

But equally, what happens if the business’s revenues fall short of the sales, below which no bonus would have been paid in the first place?

For example, if the earnout is based on revenues, and let’s say you agree that if sales exceed £2,000,000 for an earnout bonus to be paid, what should happen if sales fall short of £2,000,000?

In this scenario, it’s only fair that you should protect yourself against the downside too, so that the amount paid for the business will be equally reduced if sales are below the agreed amount, which in this case is sales of £2,000,0000.

This is what’s called a quid-pro-quo, or a win-win scenario.

Do business sellers like earnouts?

But it’s likely you may receive resistance from a seller, if you ask to protect yourself from the downside of an earnout, but by doing so, this will focus the seller’s mind on making sure the numbers included in the agreement for revenue, bonus percentage and timeframe are fair for you and the seller.

However, if you would prefer to be in control of the amounts paid for the business, if an earnout falls due because the business has performed well, you simply pay the increased amount due.

But if on the other hand the business doesn’t perform well, but you’ve already paid the owner the price upfront on completion, it’s much more difficult to clawback any amounts due under the agreement.

This is why using seller financing to buy a business is a good way to fund the acquisition, because so long as the earn-out clawback period falls within the payment period for the seller financing, you simply reduce future seller financing payments by the amount of clawback due back from the seller.

When I sold one of my businesses, the sale and purchase agreement (or SPA) included this type of quid-pro-quo (i.e. something for something) clause, which meant that if the business did better than expected, the buyer would pay more, but if it did worse than expected, then he’d pay less.

Additionally, when I sold this business, I agreed to seller financing the deal too, which meant that should the revenues of the business fall short of the amount included in the sale and purchase agreement, the buyer would simply reduce the future payments accordingly.

Fortunately for me this didn’t happen, so the seller financing was paid in full, but also, and unfortunately, the business performed such that I didn’t receive an earnout bonus payment either.

By agreeing to an equal and opposite earnout clause in this way, you and the seller share the risk.

But by using seller financing to fund the business acquisition, you also protect yourself from having to seek a repayment from the seller of the upfront acquisition price, should the business perform badly post-sale.

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.