Structuring a Business Acquisition as an Earned Buyout
by Brad Mix | June 4, 2024
An earned buyout, often referred to as an earnout, is a strategic approach to business acquisitions where a portion of the purchase price is dependent on the future performance of the business. This structure not only mitigates risk for the buyer but also incentivizes the seller to remain invested in the company’s success post-acquisition. The earnout model is particularly useful in scenarios with uncertain future performance, high growth potential, the need for seller retention, risk sharing, and valuation discrepancies.
Key Features of an Earned Buyout
- Performance-Based Payments: In an earned buyout, future payments to the seller are contingent upon the business achieving specific financial or operational targets. These targets can include metrics like revenue, profit margins, or other key performance indicators (KPIs).
- Risk Mitigation: By tying a portion of the purchase price to the company’s future performance, the buyer reduces the risk of overpaying if the business underperforms post-acquisition.
- Incentive Alignment: Sellers are motivated to ensure the business meets or exceeds the performance targets, fostering a smoother transition and continued success. This alignment of interests between buyer and seller is crucial for the sustained growth of the business.
When an Earned Buyout is Appropriate or Commonly Used
Earnouts are particularly beneficial in the following scenarios:
- Uncertain Future Performance
- Scenario: The future earnings or revenue streams of the business are uncertain.
- Use: The earnout structure ties payments to actual performance, protecting the buyer if expected results are not achieved. For instance, a tech startup with a promising but unproven product might be sold with an upfront payment and additional payments based on revenue milestones achieved within the next three years.
- High Growth Potential
- Scenario: The business has significant growth potential not fully reflected in its current financials.
- Use: Sellers can benefit from a higher total price if the business meets its growth projections. For example, a healthcare practice projecting rapid patient acquisition and retention could structure the earnout with payments tied to patient growth metrics over five years.
- Seller Retention
- Scenario: The seller’s continued involvement post-acquisition is critical for the business’s success.
- Use: Earnouts encourage the seller to remain engaged and help the business achieve performance goals. A professional services firm might structure an earnout with payments based on client retention rates, ensuring the seller’s active participation in maintaining client relationships.
- Risk Sharing
- Scenario: Specific risks or uncertainties exist, such as pending contract renewals or market volatility.
- Use: Earnouts distribute the risk between buyer and seller. A government contractor facing uncertain contract renewals might agree to an earnout with payments contingent on securing and renewing key contracts.
- Valuation Discrepancies
- Scenario: The buyer and seller have different opinions on the business’s value.
- Use: An earnout bridges the valuation gap by tying part of the purchase price to future performance metrics. For instance, in the acquisition of a software company, the buyer might pay an initial sum upfront, with additional payments based on achieving specific revenue targets over the next two years.
Structuring an Earned Buyout: Hypothetical Examples
- Technology Startup
- Scenario: A buyer acquires a tech startup with an innovative but unproven software product.
- Structure: The buyer pays $5 million upfront and agrees to additional payments of up to $3 million based on the startup achieving $10 million in annual revenue within three years.
- Healthcare Practice
- Scenario: A buyer acquires a dental practice with the potential for significant patient growth.
- Structure: The initial payment is $2 million, with additional payments of $1 million tied to achieving a 20% increase in patient numbers over the next two years and maintaining a specific patient retention rate.
- Professional Services Firm
- Scenario: A buyer acquires a consulting firm where client retention is crucial.
- Structure: The buyer pays $4 million upfront, with up to $2 million in earnout payments based on maintaining at least 90% of existing client contracts and achieving a 10% growth in new client acquisitions over three years.
- Contract-Dependent Business
- Scenario: A government contractor is being acquired, with key contracts up for renewal.
- Structure: The buyer makes an initial payment of $3 million, with additional payments of $1 million based on the successful renewal of critical contracts within the next 18 months and securing at least two new contracts within two years.
An earned buyout is a versatile and strategic tool in business acquisitions. By tying part of the purchase price to the future performance of the business, it mitigates risk for the buyer while potentially increasing the final purchase price for the seller. This structure is particularly useful in situations involving uncertain future performance, high growth potential, necessary seller retention, risk sharing, and valuation discrepancies. Whether in technology startups, healthcare practices, professional services firms, or contract-dependent businesses, earned buyouts offer a balanced approach that aligns the interests of both buyers and sellers, fostering a win-win scenario.
Brad Mix
Consultants, Growth Acceleration Consultants, Manatee, Mix, SarasotaFlorida SBDC at USF
Specialty: Disaster Assistance, SBA Lending, Startup
Brad Mix has more than 20 years of experience in the financial services industry and as a business consultant. Prior to joining the Florida SBDC at USF, Mix provided consulting services to more than 2,500 businesses and assisted business owners in securing more than $100 million in capital and $60 million in government contracts. He has extensive experience with SBA loans, including 504s, Community Advantage loans, and microloans. In addition, he assists business owners in preparing business plans, financial projections, profitability improvement, business acquisitions, business valuations, marketing and capital solutions.