Navigating Earnouts in Business Sales: A Guide - Arnold Hill & Co.

Earnouts provide a mechanism for bridging valuation gaps between buyers and sellers. This is a well-used structure that allows a portion of the purchase price to be contingent on the future performance of the business, aligning incentives between both parties and mitigating risk.

What is an earnout?

It’s a contractual provision in which, following the sale, the seller receives additional payments based on the future performance of the business. These payments are typically linked, over a set period, to financial metrics, such as revenue, EBITDA, or net profit.

Pros of earnouts

• Bridging Valuation Gaps: Earnouts help buyers and sellers reach a middle ground when there is disagreement on the company's valuation.
• Reduced Risk for Buyers: Buyers can mitigate the risk of overpaying by tying part of the purchase price to future performance.
• Potential for Higher Returns for Sellers: If the business performs well post-sale, sellers can receive more than the initial agreed-upon amount.
• Alignment of Interests: As sellers may stay involved in the business during the earnout period, they remain motivated to ensure continued success.

Cons of earnouts

• Uncertainty for Sellers: There is no guarantee that the earnout conditions will be met, which may reduce the final payout.
• Potential for Disputes: Buyers and sellers may disagree on how performance metrics are measured and achieved.
• Operational Changes: The new owner’s management decisions may impact the business’s ability to hit earnout targets.
• Complexity in Structuring: Negotiating and drafting an earnout agreement requires careful consideration to avoid misunderstandings and conflicts.

Best Practices for Structuring an Earnout

Clearly Define Performance Metrics

Ensure that the targets are measurable, realistic, and agreed upon by both parties.

Set a Reasonable Time Frame

Earnouts typically range from one to five years, balancing incentives without prolonging uncertainty.

Include Protections for Sellers

Sellers should negotiate provisions that prevent the buyer from making drastic changes that could negatively impact earnout targets.

Work with Experienced Advisors

Legal, and financial professionals can help structure earnouts in a way that benefits both parties and reduces potential disputes.

While there’s no denying that earnouts can provide a pathway to successful deal-making, they also introduce a number of complexities to the process.

Asha Moore, Corporate Finance Associate at Arnold Hill & Co, says: “In today’s M&A market, earnouts have become a crucial tool for bridging valuation gaps, aligning incentives, and mitigating risk. With economic uncertainty and evolving market conditions, buyers seek to protect downside risk, while sellers aim to maximise value. A well-structured earnout not only facilitates deal completion but also ensures both parties are invested in the business’s future success.” 

If you’re considering a business sale or acquisition and want to explore whether an earnout is the right approach, get in touch with Asha today, who’ll help you structure a deal that maximises value while protecting your interests. Let’s get started…

Author, Asha Moore - Corporate Finance Associate

Asha.Moore@ArnoldHill.co.uk