Selling your business or considering it? Here’s a great explanation about earnouts from a CFO.com article entitled, “The Ins and Outs of Earnouts”.
“The sellers … may not want to sell… if the price is based on operating performance they believe is only temporarily depressed in the wake of the financial meltdown. Or they may be hesitant to sell based solely on historical performance when their businesses are in high-growth industries.
Buyers, however, want to buy on proven performance and not speculative future performance. This presents a classic situation: a buyer wanting to buy for less negotiating with a seller wanting to sell for more. When buyers and sellers cannot agree on the valuation, a way to bridge this gap is through an earnout.
An earnout is a contingent pricing mechanism. In an earnout, a portion of the purchase price is calculated by using the performance of the selling company over a period of time after the closing of the sales transaction. It rewards the seller only if the future performance actually matches the current projections of future performance.
Further, it allows a seller to exit its current investment without forfeiting the ability to share in its future growth. It also protects the buyer from overpaying if a seller’s projections are overly optimistic. In many ways, the earnout aligns the financial incentives of both the buyer and the seller.”
Read all of The Ins and Outs of Earnouts.