If you're selling your company, an earnout could be your best friend or your worst enemy. Here's why.
Believe it or not, the structure of your transaction is even more important than the price. Whats the good of a premium valuation if it you never actually get the money? But buyers are wary of giving sellers all the cash and then, after the deal closes, finding that the anticipated ROI just isnt there. A well structured transaction, even with an earnout, helps ensure the transaction consideration becomes real money for the seller.
By being flexible on transaction structure, the seller can maximize the total deal value. If a buyer wont pay the price a seller wants all in cash and all at closing, then an earnout might be the best way to bridge the valuation gap and get the deal done.
But whether the seller ever realizes any payment under an earnout depends on how the earnout is negotiated. This makes the critical difference between an earnout that helps a seller get the price they want, or an earnout that evaporates and leaves the seller angry, frustrated and feeling cheated. Sellers should get experienced help to navigate this difficult process.
Here are some tips for sellers negotiating an earnout:
First, make sure the amount paid at closing is satisfactory at a minimum, even if you don't get another dollar. If it falls short of that minimum amount, then continue working the deal to reach that point.
Second, make sure the earnout is achievable and within your ability to influence after closing. Payments under an earnout structure are usually tied to performance targets, so the definition of those targets is critical. Its not effective to tie your earnout consideration to a target that is outside your control. Its also not a good idea to tie the earnout to a metric where the sellers and buyers interests are not well-aligned. For example, a buyer might circumvent a profit-based earnout by allocating corporate G&A costs into the seller's P&L.
Third, determine what commitments you need the buyer to make in order for the earnout to be achievable. Negotiate for those to be included within the definition of the earnout. For example, do you need a certain marketing and sales budget to hit future revenue objectives?
Fourth, identify reasonable decisions a buyer might make in the future that could jeopardize your ability to achieve the earnout. A buyer might decide to re-focus on its core business and the sell the product line on which your earnout depends. Negotiate terms that protect you from such eventualities.
It's true that a badly structured earnout is useless or worse. It might cost you your company.
But a well structured earnout, based on achievable objectives that takes advantage of the aligned interests of buyer and seller, can be an effective way for a seller to realize their dreams.
A version of this article originally appeared in SoftLetter and Software Success.