What is an earnout and how earn-outs in acquisitions work? Should you have one in your term sheet? What key terms do you need to watch and negotiate as a founder selling a startup?
If you thought selling your own product was a challenge, welcome to a whole new world of selling fun. You’ll never sell anything as complicated as a startup.
This may make those Einstein proof mobile phone bills and plans of yours look like elementary math and as basic as a paper cup at your childhood lemonade stand.
One of the fun quirks of getting acquired are earnouts. They can be a nightmare. As well as a goldmine opportunity to double the size of your exit. Here’s what you need to know about them.
So How Earn-Outs in Acquisitions Work?
An earn-out is one of those quirky and controversial clauses in your term sheet that can either rob you blind for millions of dollars, or multiply your exit price. It’s all in how you use it, and what you negotiate.
As the name suggests, an earn-out gives you the chance to earn additional money out of the deal. This is typically done by achieving specific milestones and targets after the sale is completed.
More recently, some professional high volume M&A departments are simplifying this, and are making it time-based, rather than performance-based. Usually spread out for several years after the closing.
What’s the Purpose of an Earn-Out?
Some of the individuals that act as an M&A advisor might argue that an earn-out is the ingenious brainchild of some lawyer or Wall Street wolf, intended to enable acquirers to get out of paying the cover price. That may be true, but it can also be a great tool for maximizing the value of your startup and what you’ve built.
From a buyer’s perspective, an earn-out reduces risk, makes the cost more palatable, and may create a massive discount on purchasing your company.
In the example of a strategic acquisition, when thinking how earn-outs in acquisitions work it basically gives the buyer a chance to test drive the merchandise, get integration achieved, and secure the profitable performance you sold them on in your pitch book.
Mastering the storytelling side and how you are positioning your business is done via your acquisition memorandum. For a winning acquisition, memorandum template take a look at the one I recently covered (see it here) or unlock the acquisition memorandum template directly below.
They can use the enhanced proceeds of their new acquisition to pay you back over time through the earnout clause. If your assets fail to perform for them, then they don’t have to pay anything else.
From a buyer’s perspective, it can at first be difficult to see any sense in why you would take an earn-out. However, if you really believe your venture and this new merger can produce even bigger things and continue to grow, an earn-out gives you a chance to get paid even more for proving it.
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