An earnout is a type of payment agreement which is sometimes used in a business acquisition. An earnout is a buyer’s commitment to pay the seller a certain amount of the money tied to future performance after a sale. It bridges a valuation gap between what the seller wants out of the business and what the buyer can safely pay.

Under an earnout agreement, the seller receives part of the purchase price up front, and additional funds over time. The terms of the earnout are written into the sales contract.

Earnouts will probably play a bigger part of deal structure in the months ahead.  If business recovers, buyers and sellers both come out winners.

An earnout can be used for different reasons:

To tie the acquisition payout to future performance

An earnout, in a business acquisition context, is an arrangement in which the buyer doesn’t pay the entire purchase price up front but agrees to pay a certain amount now and more later depending on how well the business performs in the future.

To bridge the pricing gap

If there is a valuation gap between the buyer and seller, and there always is, it is a way to bridge the gap. The seller may be placing a heavier emphasis on the company’s projections, and the buyer placing most of the company’s value on its present and past performance. An earnout agreement is a useful tool to get the deal done. In an uncertain economic climate, there may be more willingness to take the wait-and-see option offered by an earnout-structured acquisition.

To mitigate risk factors

A form of escrow account can be established to mitigate certain risk factors inherent in the business, such as customer or product concentration issues or a down revenue trend. Funds will be paid out conditioned upon meeting certain thresholds over a defined time frame.

PROS

From the buyer’s perspective, earnouts obviously reduce the initial cash payment and provide a level of insurance by minimizing the risk of overpaying for future revenues and profits.

From the seller’s perspective, they are able to structure the transaction to realize the level of value that they think is in the business if it performs as they believe it will. It allows the seller to feel that they aren’t leaving any upside on the table. Earnouts can also provide a vehicle to defer taxes.

CONS

From the buyer’s perspective, integration issues are of paramount concern. Earnouts don’t work if the buyer plans to significantly change or meddle with the operation after the acquisition.

From the seller’s perspective, the seller is delaying their receipt of full payment and is dependent on the financial health of the buyer. They also run the risk of unforeseen circumstances and disputes surrounding the earnout if operational changes are made that interfere with the ability to achieve earnout targets.

Read “How To Structure An Earn-out” on Inc: