As it pertains to transactions, an earnout is basically an agreed-upon payment to the seller contingent on future events, or for future conditions being met.
For example, in its simplest form, let’s say a company is being sold and the two parties agree that when the company hits $10 million in revenue, the seller will receive an earnout of $250,000. That is just one type of earnout, as they can vary greatly in size, structure and complexity.
As far as why earnouts exist, the simplest explanation is that buyers and sellers often differ in their future expectations of a business. Earnouts help “bridge the gap” in terms of pricing the business, allowing the two sides to find a middle ground, particularly now in the face of an uncertain economic environment.
Two additional benefits are that earnouts allow a transaction to take place with less cash being required up-front. And they also help control potential issues with competition, as the sellers technically are “leaving money on the table.”
Additionally, earnouts keep the sellers engaged in the business, as they now have a clear incentive to help ensure its continued success.
The common types of earnouts are EBITDA, revenue, gross profit and milestone. EBITDA are the most common, while gross profit earnouts are more popular than ever at the moment. The structure of the earnout typically falls into one of three categories:
- Cliff: The earnout is earned when a sales target is exceeded.
- Tiered: The earnout is earned on a sliding scale as EBITDA is viewed through various thresholds.
- Binary: The earnout is earned based on a “random” metric, like whether a certain number of customers are retained or whether a particular drug reaches clinical trials, for instance.
The two primary techniques for valuating earnouts are (1) the Scenario Based Method, which looks at a different scenarios, such as a base case, an optimistic case and a pessimistic case, and (2) the Option Pricing Method (simulation method), which incorporates thousands or even hundreds of thousands of scenarios to determine the value of the earnout. Option Pricing has become more popular this year due to the uncertainty of the COVID-19 business landscape.
