Who Benefits from a Business Earnout? A Buyer’s Guide to Smarter Acquisitions

It’s no surprise that settling on a business price can be challenging, given that negotiations often involve conflicting valuations and varying expectations. Earnouts are a standard tool used in many deal structures to address these issues and bridge the gap between buyers and sellers. Keep reading to discover who benefits from a business earnout and how this approach works.

Understanding Earnouts

An earnout is a type of purchase agreement in which the seller receives part of the purchase price at a later date, contingent on the business’s post-closing performance. You’re more likely to see them used in middle market deals rather than in smaller main street transactions.

Two important parts of structuring earnouts are defining the metrics by which future performance will be measured and defining the earnout period, the timeframe in which the business is evaluated, and the seller can begin receiving additional compensation. Common earnout metrics include customer retention, profits, revenue, and sales growth. The earnout period must also be negotiated between the buyer and seller, but it typically lasts between one and three years.

Who Benefits from Them?

Both buyers and sellers can benefit from a business earnout, as it can create a more flexible and mutually advantageous deal. However, despite the potential benefits, there are also risks for both parties. The performance metrics and terms of the earnout can be complex, and disagreements may arise if expectations are not clearly defined. This is why it’s important to thoroughly negotiate and carefully structure the agreement to ensure both sides are clear on expectations and terms, minimizing potential conflicts and effectively aligning interests.

Advantages of Business Earnouts for the Buyer

Business earnouts offer buyers a unique opportunity to structure deals that provide flexibility and reduce upfront risks. By tying part of the purchase price to future performance, they can create more attractive terms and ensure the deal aligns with long-term business goals. Here are a few ways buyers typically benefit from business earnouts.

1. Reduced Uncertainty and Protection Against Underperformance

Sometimes, buying an existing business may come with a feeling of uncertainty. After all, you’re taking on something built by someone else. However, structuring your deal with an earnout can help ensure greater confidence. Most of the time, the seller will be unlikely to agree to an earnout unless they truly believe in the company’s potential.

2. Better Cash Flow Management

Since part of the purchase price will be paid out later through earnout payments, you don’t need to fund the entire amount upfront. This can reduce your initial borrowing needs and allow for more effective budgeting. By spreading the financial impact over time, you can maintain a healthier cash flow and allocate resources more efficiently in the early stages of ownership.

3. Reduced Risk of Overpayment

Since earnout payments are tied to the business’s performance, buyers can mitigate the risk of paying too much upfront, unlike a traditional purchase where the total price is fixed regardless of future performance. And, in the case that the business doesn’t perform well according to the agreed-upon metrics, you don’t have to make the extra earnout payments.

If you’re ready to seize the opportunity and buy a business, don’t underestimate the value of professional assistance. A business broker is an invaluable resource for navigating the complexities of a sale, from evaluating the business to negotiating terms. Their expertise helps ensure you get the best possible outcome and maximize the value of your investment. Sunbelt Business Brokers has offices across the country and is ready to help you every step of the way. Find an office near you today!