Definition
An earnout is a financial agreement in which a portion of the purchase price of a company is deferred and awarded to the seller based on specified future performance milestones or financial targets. It is often used in mergers and acquisitions to bridge a valuation gap between a buyer and a seller. Essentially, it serves as a risk mitigation strategy for the buyer if the acquired company does not perform as expected.
Key Takeaways
- Earnout is a contractual provision in mergers and acquisitions where the seller must ‘earn’ a part of the purchase price post-acquisition, based on the performance of the company.
- It is often used as a solution to settle price disagreements during negotiations between the buyer and the seller, allowing the price to be influenced by future financial results.
- While earnouts offer benefits like reduced risk for buyers and potential upside for sellers, they could also create disputes if the acquired business doesn’t meet the set financial targets or if the parties disagree on the management approach post-acquisition.
Importance
An earnout is an important finance term often used in mergers and acquisitions.
This provision ensures that the seller of a business receives future financial benefits if the company meets certain financial goals.
Essentially, an earnout is a risk-allocation tool used when the buyer and seller have different views on the future profitability of the business.
It aligns the interests of both parties by allowing the seller to participate in the future success of the business, while giving the buyer a level of protection if the projections are not met.
Moreover, earnouts can facilitate deals that might not occur without this contingent payout, making it crucial in business transactions.
Explanation
An earnout is a mechanism used to bridge a valuation gap between a buyer and a seller during a business acquisition. It outlines the terms for the purchase price’s additional payment that is reliant on the acquired company achieving agreed-upon financial goals post-acquisition. Essentially, an earnout can be seen as a risk allocation tool as it ties part of the acquisition cost to the future financial performance of the acquired business.
This encourages a smoother transaction process, especially when there may be disparate views about a company’s worth or potential growth. Earnouts offer a strategic tool to make acquisitions more appealing for both parties. From the buyer’s perspective, the earnout ensures that they are not overpaying for a business if the future performance does not match the seller’s predictions.
In addition, it helps the buyer by spreading the acquisition cost over an extended period. From the perspective of the seller, an earnout can maximize their return from the sale, particularly if they are confident in their business’s future performance. An earnout also often involves the seller remaining in the company after the sale to ensure the company meets the earnout targets, allowing them to influence the achievement of those targets.
So, in essence, earnouts are used to facilitate and provide flexibility in M&A transactions while ensuring the risks and rewards are shared by both parties.
Examples of Earnout
Google and DoubleClick: In 2007, Google acquired the ad-tech company DoubleClick for approximately $1 billion. As part of the agreement, a portion of the purchase price was held back as an earnout. This earnout was contingent on DoubleClick’s performance over the next few years. The purpose of engaging this term was to keep DoubleClick’s management motivated and aligned with Google’s objectives, as well as to reduce the overall risk for Google if DoubleClick’s earnings didn’t meet expectations.
Pfizer and King Pharmaceuticals: In 2010, King Pharmaceuticals was acquired by Pfizer for approximately $6 billion. The deal included an earnout clause of $
3 billion which was tied to the future success of King’s new abuse-resistant painkiller, Embeda. Pfizer would only pay this earnout if the drug met certain revenue targets set in the agreement. This deal used the earnout clause to transfer some of the risk exposure onto the sellers.SoftBank and ARM Holdings: In 2016, SoftBank, a Japanese multinational conglomerate, purchased the British semiconductor and software design company ARM Holdings for approximately $31 billion. Part of the agreement specified that SoftBank would pay former ARM employees about £
3 billion ($5 billion) in an “equity incentive plan,” which can be viewed as a type of earnout. This promise was to ensure that top performing ex-employees of ARM Holdings would continue to work towards the profitability and success of the firm after acquisition.
Earnout FAQ
What is an Earnout?
An earnout is a contractual provision stating that the seller of a business is to obtain additional payment in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or profits.
How does an Earnout work?
After base purchase price of a business is paid at closing, the seller can potentially earn additional payments over a certain period of time. These additional payments are contingent on the business’s performance, based on agreed-upon financial metrics like revenue or earnings before interest, taxes, depreciation, and amortization (EBITDA).
What is the purpose of an Earnout?
Earnouts are used to bridge a valuation gap between a buyer and a seller. Often, the seller of a business is optimistic about the future prospects of the business, while the buyer is more risk averse. An earnout can be used to provide additional compensation if the business performs well in the future.
What are the risks of an Earnout?
Some risks associated with earnouts include potential disagreements over the financial results of the business, disputes over management decisions, and changes in market conditions. This requires the parties to negotiate the terms of the earnout carefully and to have clear provisions for resolving any disputes.
Related Entrepreneurship Terms
- Mergers and Acquisitions
- Contingent Payments
- Post-Acquisition Performance
- Buyer-Seller Agreement
- Deferred Payment
Sources for More Information
- Investopedia: This site provides comprehensive explanation of various terms related to finance including Earnout.
- Corporate Finance Institute: It is a reliable source for obtaining in-depth knowledge about various concepts of finance such as Earnout.
- Entrepreneur: This webpage gives practical insights on many finance terms like Earnout from business perspective.
- Practical Law UK (Thomson Reuters): They provide valuable legal perspective on finance terms like Earnout.
