What is an earnout?
Takeaway: An earnout is a provision in an acquisition agreement that requires the buyer to pay additional compensation if certain post-acquisition performance targets are met. It serves as a tool to bridge valuation gaps, align interests, and mitigate risks, but it also carries potential challenges such as disputes over targets, integration difficulties, and retention issues.
When it comes to startup acquisitions, the terms of the deal can make all the difference. One common component of these transactions that founders, investors, and acquirers need to understand is the earnout. In this post, we'll delve into what earnouts are and how they operate.
What is an Earnout?
An earnout is a structured agreement in an acquisition deal that requires the buyer to pay additional compensation to the seller if certain financial targets or milestones are achieved post-acquisition. The concept is akin to performance-based compensation, which is contingent on the startup's future performance.
Earnouts provide a way to bridge valuation gaps between the buyer and the seller. They are particularly common in transactions involving startups, where the future performance may be uncertain, and the buyer and seller may have different views on the company's potential growth.
How Do Earnouts Work?
In an earnout agreement, specific metrics or milestones are identified that will trigger additional compensation. These might include revenue targets, customer acquisition goals, or product development milestones. The earnout period can vary but typically lasts between one to five years post-acquisition.
If these targets are met within the defined time frame, the seller (usually the startup's stockholders) will receive additional payments, which can be in the form of cash, equity in the acquiring company, or other forms of compensation.
Why Use an Earnout?
There are several reasons why earnouts are used:
Bridging Valuation Gaps: As mentioned earlier, earnouts can help bridge the gap between the buyer's and seller's valuation of the company. If the seller believes the company will perform well in the future, an earnout allows them to benefit from this future performance.
Aligning Interests: Earnouts help align the interests of the buyer and seller post-acquisition. The seller has a vested interest in the company's continued success, which can promote a smoother integration and motivate the startup team to continue performing.
Risk Mitigation: From a buyer's perspective, earnouts can help mitigate risk in the transaction. If the startup does not achieve the agreed-upon targets, the buyer is not required to pay the additional compensation.
Risks and Challenges with Earnouts
While earnouts can be beneficial, they also come with risks and challenges:
Disputes: There can be disagreements over whether the defined targets have been met, especially if the earnout agreement was not clearly drafted.
Integration Difficulties: If the seller is focused on achieving earnout targets, it might result in resistance to changes that the buyer wishes to implement post-acquisition.
Retention Issues: If the earnout period is too long, it might lead to retention issues, as key team members might leave the company once the earnout period is over.
Conclusion
While earnouts can be a useful tool in a startup acquisition, they require careful planning, clear drafting, and thoughtful implementation to be effective. It's recommended that both buyers and sellers consult with experienced legal and financial advisors when structuring and negotiating earnout provisions.