How to Measure an Earnout: Picking a Metric

Are you purchasing a business and struggling to reach an agreement with the seller? Or maybe you’re an aspiring business owner, considering the different types of purchase agreements? In either case, business earnouts can be a powerful tool for structuring a deal that aligns with both parties’ expectations. The key to a successful earnout lies in choosing the right metric to measure the business’s future performance. Read on to learn how to measure an earnout and pick the right metric to ensure a fair and successful transaction.

How Earnouts Work

An earnout is a type of purchase agreement used in business sales. In an earnout, the buyer pays part of the purchase price at a later date, contingent on the business meeting certain performance metrics, rather than in a single lump sum at purchase. Earnouts can be advantageous for both the buyer and the seller as they help bridge the gap of differing opinions and expectations, especially if there’s a valuation gap. For the buyer, earnouts also provide flexibility and help reduce the risk of overpaying, ensuring that the final purchase price is based on the business’s actual performance rather than speculative projections.

Common Types of Earnouts

One of the most important parts of structuring an earnout is defining the metrics by which business performance will be evaluated. Clear and measurable metrics help ensure transparency when calculating earnout payments and determining when they should be paid. Here are two types of earnouts and the metrics in which they’re commonly measured by.

Milestone-Based Earnouts

In milestone-based earnouts, payments are contingent on specific business achievements or milestone events. These milestones can range from completing a product launch to securing a certain number of new clients. Other common examples include hitting pre-determined sales targets, securing new partnerships, or achieving other operational goals.

Performance-Based Earnouts

Performance-based earnouts are measured by the performance of the business post-sale. Earnout payments are typically linked to financial performance metrics, such as revenue, gross profit customer retention, or EBITDA. Sellers usually prefer performance-based earnouts because they focus on more tangible and measurable results, which can be verified through the business’s financial reports and financial statements.

Which Type of Earnout is Best for My Deal?

Buying a business is a complex process with many steps, and if you choose to do an earnout, selecting the right type is a crucial part of the process. The type of earnout you should choose depends on the specific goals and risks associated with your transaction. While earnouts do have several advantages for the buyer, you’ll want to weigh these benefits against the disadvantages to ensure the structure makes sense for your unique deal.

If you’re considering an earnout, it’s best to work with a business broker who can help you assess your options, evaluate the risks and rewards, and ensure the terms are fair. Sunbelt Business Brokers has a team of experienced professionals who can help you understand all of your payment options, including earnouts, and their potential outcomes. We’ll work with you to help ensure that your decisions throughout the buying process align with your long-term goals and set you up for success. Find an office near you to speak with a broker.