When buying a company, buyers often value them lower than what sellers think they are worth.  This is a natural and expected “tug of war” that goes on with most acquisitions.  It is rare that the parties agree on the value of a company without some negotiation.

Third party financing also plays a significant role.  When buyers seek a loan from a seasoned bank, the bank is likely to lend money mainly on the value of hard assets of the company (e.g., inventory, equipment, real estate, etc.).  Banks typically do not like to lend money on what is referred to as “goodwill” or “blue sky.”  This is because, in the event of a default by the buyer on the note, it is almost impossible for a bank to “sell” that goodwill to a third party and obtain any proceeds to apply against the loan.  Thus, to a bank, goodwill is not worth much.

Sellers often think their companies are worth more than buyers do because of this goodwill component.  Buyers usually think the goodwill component should prove itself out over time before the buyer should have to pay for it.  After all, the amount of the purchase price allocated toward goodwill is usually arbitrary, and based on some general industry standards or rules of thumb as to how the company should perform in the future.

One way to bridge this valuation gap is for the parties to agree to what is referred to as an “earnout provision.”  In its simplest form, an earnout means that the parties agree to allocate some portion of the total purchase price to goodwill, but payment of that amount to seller is contingent upon the company performing (after the closing) consistent with financial metrics or objectives that parties agree to prior to closing the deal.

For example, let’s assume in a $4.0 million purchase price transaction, the parties agree that there are $3.0 million of hard assets, and $1.0 million of goodwill.  The parties negotiate that the buyer will pay the seller this $1.0 million of goodwill, but only if the company achieves $1.5 million of gross revenue each year for 3 years after the closing.   So in effect the seller agrees to accept a $1.0 million promissory note from the buyer, but the seller understands seller will only get paid that amount if the company does what it is expected to do in terms of performance.

There are an infinite number of ways to negotiate and structure earnout provisions.  A common one is a “cliff earnout” wherein the seller only gets paid anything if the company’s performance achieves the agreed upon performance metric within the defined period of time.  If the company’s performance is $1 short, then none of the earnout gets paid.  In our example above, if the company only achieved $4.49 million in sales (less than its $4.5 million target), the buyer would not have to pay any of the $1.0 million earn out provision, and the note would be forgiven.  The net result is that the buyer only paid $3.0 million for the company.

Earnouts could also be structured such that the total payment owed to the seller under the earnout note would be prorated based on the company’s performance.  This prorated method could potentially result in the Seller receiving some fraction of the total amount owed under the earnout note, but it could also result in the seller obtaining an even higher amount of payment for goodwill than what was negotiated.  For example, assume that the seller’s earnout metric is structured such that that seller would receive 25% of gross sales over a 3 year period to be applied against the earnout note.  Using our $1.0 million goodwill example above, if gross sales in 3 years total $5.0 million, then seller could receive $1,250,000 under the earnout formula (well above the $1.0 million note).  Conversely, if gross sales are only $3.5 million, then the seller would only receive $875,000 (less than the expected $1.0 million payment).

While there are an infinite number of ways to structure an earnout, the concept is a relatively simple one.  Payment is made only if performance is achieved.

If you are looking to buy or sell a company, contact the business lawyers at Steimle Birschbach, LLC.  We would be honored to represent you.

This blog post is provided for informational purposes only and by its very nature is very general.  This information is not intended as legal advice.

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