Earnouts 101: How They Impact Sell-Side M&A
Even though M&A transactions are the final steps in selling a business, they’re usually very lengthy. As you let go of your legacy, you need expert assistance with these complex processes.
Unfortunately, even with an experienced intermediary on your side, these final proceedings can face a deadlock. Sometimes, a well-planned negotiation strategy will go south, and all that time and effort will go to waste.
A common cause of deadlock is the buyer’s risk which your M&A advisor can mitigate with earnouts. In as much as they’re controversial to M&A, earnouts come in handy when a deal is likely to flop.
Let’s examine when earnouts are appropriate.
What is an Earnout?
Before we begin, you must understand what earnouts are. In simple terms, earnouts bridge the substantial gap between your business valuation and the buyer’s estimated value of the business.
Sellers will always perceive their businesses to be of maximum value, but buyers will not always agree.
When an earnout is tabled, the seller will withhold an agreed-upon percentage of the official sales price until the business meets specific financial merits. Earnouts change the deals of a transaction in order to save a sinking ship.
Why do Earnouts have a Bad Reputation?
On the surface, earnouts seem unfair to seller, and can also have adverse outcomes for the buyer. When it is introduced, the seller has to work overtime to ensure the buyer is satisfied by the business’ performance.
If the business fails to deliver, the seller doesn’t get the withheld percentage of the agreed-upon selling price. Sellers then lose twice because they weren’t compensated for their extra effort to ensure the business fulfils the buyer’s conditions.
Another reason why earnouts have such a bad reputation is because they’re paid in future, often without interest. If the sell-side party had put cash towards driving up the value of the business, it cancels out with the earnouts.
Can Earnouts be Helpful?
Every solution has its upside and downside, but does the good outweigh the bad when it comes to earnouts?
From the buyer’s perspective, this is a win because it’s an excellent bargaining chip to ensure they get the business they signed up for.
Sellers, on the other hand, should steer clear of an earnout; especially if you’re selling an established business with a solid financial history.
So does Earnouts Help Sellers at All?
Well, if you’re letting go of a startup that barely has a financial history, an earnout could work in your favor. Work with an experienced M&A advisor who has the technical knowledge to help you arrive at an accurate business valuation.
Are you looking for the perfect exit from your business? The best strategy is to double down on your negotiation strategies. Focusing on an earnout that’s not even guaranteed is futile for anyone seeking financial freedom.
Earnouts are controversial because even though they seem like the way out in deadlocks, they might cause even more harm in the end. Make sure you work with an experienced M&A advisor for the best negotiation strategies. You need expert assistance to successfully close M&A deals because they’re quite lengthy and complicated.