Earnouts 101: How They Impact Sell-Side M&A

M&A transactions are the complex and lengthy final step business owners take in their journey towards letting go of their legacy. Unfortunately, even with an experienced investment banker on their side and a well-planned negotiation strategy, that final step can face a deadlock.One of the most common reasons for a deadlock in M&A negotiations is the buyer’s risk. Investment bankers can mitigate the buyer’s risk—while also pushing potential buyers towards transaction settlement—with earnouts. Earnouts are controversial to M&A deals, so let’s examine when they may be appropriate.

What is an Earnout?

With an earnout on the table, a percentage of the agreed sales price will be held back until certain financial metrics are met. When an earnout is included in the structure of a transaction, it changes the terms of the deal.Earnouts are included in an M&A deal when there is a substantial gap between the seller and buyer’s estimate of a business’ value. While every seller may believe their business is worth maximum value, sometimes buyers aren’t convinced; an earnout may bridge that gap.

Why Do Earnouts Have a Bad Reputation?

On the surface, earnouts may seem like an unfair solution for sellers, and can even have negative implications for buyers. With an earnout in place, it’s now up to the seller to work overtime and to ensure that the business delivers. This adds more risk for the seller—in fact, the seller isn’t even truly being compensated for the time and risk involved in this option.Earnouts are paid in the future and don’t often earn interest. So, at the end of the day, the sell-side party could have put even more cash towards proving their business’ value than what they could have earned from a well-negotiated deal with an experienced investment banker.

Can Earnouts Be Helpful?

In short, an earnout is most helpful towards mitigating the risk of a transaction for the buyer. Unless you’re selling a startup business or one that lacks the financial history for easily proven/accurate valuations, experienced M&A advisors should steer you clear of an earnout. Rather than focusing your energy as a seller on meeting the goals of an earnout that aren’t even guaranteed, it would be more beneficial to double down on your negotiation tactics with a trusted investment banker.

Kratos Capital Minimizes Risk for Sellers Through Our Proven Transaction Approach

Even though we value the education of all things M&A, at Kratos Capital, earnouts are typically not the approach that we take to sealing a deal. Our experienced investment bankers will exhaust all options in a transaction before structuring an earnout in a sell-side deal.We understand your need to get what you want out of your transaction and will use all of the tools in our arsenal to ensure that your company sells at maximum value. Contact us today to learn more about our process and to schedule a consultation.