How Do Earnouts Work When You Sell a Business? | Jesse Welch, MidCap Global

Joshua Wilson: 0:00

how do earnouts work when you sell a business, you know, to private equity?

Jesse Welch: 0:03

Yeah, so earnouts are I have a love-hate relationship with earnouts because I understand why they exist. but an earnout is basically the part of the price that you only get if the business hits certain targets after you sell it. So you think of it like you you're betting on the same horse, but now it's got a new jockey. the reason buyers use them is because sometimes a seller thinks that a business is worth more than a buyer's willing to pay and they'll use an earnout basically to bridge that gap. They're only going pay for that growth once they see it and it's been proven. Like I said earlier, they're very current, they're very common. There's a company called Acquiom. They do thousands of private deals and they publish research and outside of life sciences. they find that earnouts pay out about 21 cents for every dollar that is promised. So and about half of them paid zero. and like I said, they're they're they exist in about a quarter of all deals. So if you're offered one, there's there's three things you gotta look for in that purchase agreement. First is the metric. you know, if the target is EBITDA, the buyer now controls costs that decide it. So if you have a $2 million earnout, but next year's EBITDA has to hit $3.3 million, that new owner they might add a management fee. They might move some overhead onto your books. And now your EBITDA this coming year might only hit $3.2 million. Well, that $100,000, if it's all or nothing, that might cost you$2 million because you're going to get zero. So try to make it based on revenue. revenue is harder for a buyer to move. The second thing is the definition. You want to make sure that it's the same EBITDA that they valued you on with the same add-backs and the same accounting. you wanna check who calculates it, how long you have to dispute it in case you disagree with with what they come out with, because at the end of the day, they they don't wanna. make a judgment call. They want the math to make the judgment call. That way they're not negotiating. And then the third thing is does the buyer have to run the business in the exact same way that you ran it or do they have sole discretion to run it however they want? And also what happens if they, if they sell it before they eBIT or if they sell it before that earnout or whatever target that earnout is is measured? You want to make sure if they sell it or fold it into a new company that you get that earnout and that doesn't disqualify you. And this isn't buyers being villains. They're just they're running their business and that's how they have to do it. And your earnout is just one line item in their entire budget. So before you sign, make sure you know who's writing the rules, or at least if you can't be the one writing the rules, because I can promise you, they are now the ones riding the horse.