When an “earnout” is agreed, the buyer agrees to pay, in addition to the cost of acquiring a company, also a “bonus”. Under certain conditions.
When there are strong conflicting interests (and usually there are), a deal is almost never easy. The seller will always claim that his company is worth something more while the buyer less. But no one is able to prove its “actual” value. Earnout is to solve this problem.
The logic is simple: The sale of a company, if an earnout is agreed, shall be concluded (close) at the price offered by the buyer. Hence, the seller will not be harmed if it is worth more. Targets are set by the parties. In case these are achieved, the seller will have “proved” that his company is worth more than what he has already received, and therefore will be entitled to receive the agreed bonus.
This bonus will not necessarily be a specific amount: Its type, the method of its calculation and the period in which it is calculated are to the discretion of the parties.
Example: It may be agreed that the seller receives a percentage (e.g. 2%) of the company’s profits for the next three years. If the seller is confident about the capabilities of his company, it is easy to take the risk that his fee be dependent on his company’s performance.
This is, of course, a simplistic approach.
The risks and the opportunities
While earnouts seem to be something very simple and attractive, it entails many risks. What if, in our example, the buyer makes sure that the profits of the company for the first few years be hidden, by exaggerating, say, the costs? One solution would be for the seller to remain in the company’s management. Another would be that the earnout be dependent on other factors such as, for example, the company’s turnover or the company’s share of the market.
The problem that the earnout is to solve, is that of the “moral hazard”. Prior to the sale, the seller will try to inflate the value of the company while the buyer to reduce it. After the sale, the buyer will try to “hide” the factors that will trigger the earnout while the seller to highlight them.
So, more data is needed to get into the equation in order for both sides to be secured. Nevertheless, with the right planning (at the negotiations stage and when drafting the agreement), earnout can solve enormous problems.
Thus, the most important thing to be achieved through earnout is for agreements to be reached: Agreements, which, probably, would have never been possible as the buyer and the seller do not have the same view. The earnout gives time to both parties to “look through the eyes of the other”. And, ultimately, to make profitable business transactions.
Υ.Γ. The article has been published in MAKEDONIA Newspaper (December 9, 2018).