The Closing Argument

Earnouts Are Common. But the Terms Determine What You Actually Receive

Key takeaways

• SRS Acquiom found that, across private deals with earnouts outside life sciences, sellers received about $0.21 for every $1.00 they could have earned under the earnout terms.
  

• An earnout can raise the stated sale price without increasing the cash paid at closing. The payout depends on targets the business must meet after the buyer takes control.
  

• Before agreeing to one, calculate what the terms would pay if the business repeated its most recent year’s results under the buyer’s operating plan.

A seller agrees to a $13 million price, with $10 million due at closing and up to $3 million over the following years. The seller may describe that as a $13 million sale. The buyer must fund $10 million at closing, and the remaining $3 million is contingent on the business meeting specified targets. Across private deals with earnouts outside life sciences, sellers received an average of 21 cents per dollar they could have earned under the earnout terms, according to SRS Acquiom.

Just over half of those deals paid any earnout. Among deals that did pay, sellers received approximately half the maximum available. Deals with $50 million or less paid at closing generally produced lower earnout payouts than larger deals. In SRS Acquiom’s lower-middle-market data, 29% of deals with closing payments at or below that threshold included an earnout. For sellers, the figures make the earnout targets worth a close look. These payments appear in nearly 3 in 10 deals of this size, yet sellers in this segment generally collect less of the potential amount than sellers in larger deals.

The seller may see the earnout as a delayed payment for a business that is performing well. The buyer estimates how likely the business is to meet each earnout target and what it may ultimately have to pay. A $3 million maximum earnout therefore does not enter the buyer’s deal model as a certain $3 million cost. Increasing the earnout can help the parties agree on a higher headline price without requiring the buyer to pay that additional amount at closing.

The earnout terms determine how likely the seller is to receive that additional payment. A revenue target can be missed when a large customer delays an order, or the buyer changes the price. An EBITDA target can be missed even when sales grow if the buyer adds staff or incurs expenses during the measurement period. Sellers need to know which decisions the buyer controls, and how those decisions could affect the earnout.

That is where apparently small drafting choices matter. The agreement should define the measurement period, accounting methods, allocation of shared costs, and what happens if the buyer combines the acquired business with another operation. It should also specify when results are reported and how disagreements are resolved. Without those terms, the seller may reach the end of the earnout period unable to verify how the buyer calculated the payment.

SRS Acquiom’s historical 21% payout rate would put the $3 million maximum earnout in the opening example at $630,000. That is a comparison based on past deals, not a forecast of what every seller will receive. That depends on the targets, the buyer’s control over the business, and how the earnout payment is calculated.

Before the next term sheet, put the earnout terms on one page: record the target, measurement period, accounting rules, buyer operating assumptions, reporting rights, and payment due if last year’s performance repeated. Use that calculation when negotiating how much of the purchase price is paid at closing.

By the Numbers

The prime rate rose 25 basis points to 7.00% on September 17, from 6.75%. For borrowers with outstanding variable-rate loans tied to the prime rate, the increase does not necessarily affect payments that day. The timing depends on the reset provision in each signed loan note. A loan that adjusts on the first day of each calendar quarter may reflect the new rate on October 1, while another may adjust monthly or on a different date. Borrowers need to check both the rate-reset clause and the payment terms to determine when the higher rate will affect their payments.

On a $2 million outstanding balance, a quarter-point rate increase adds about $417 in interest for the first month, assuming the balance remains unchanged. If the $2 million were amortized over a new 10-year term, a rate of 10.00% instead of 9.75% would raise the scheduled payment by about $276 a month, or $3,313 over 12 months.

The Reader’s Sentiment

Prime rose to 7.00% last week, and Fed officials project another rate increase this year. If higher borrowing costs put debt service coverage under pressure for your next acquisition, which adjustment would you pursue first?

1. Defer payments on a seller note

2. Make part of the purchase price contingent on future performance

3. Increase the buyer’s equity contribution

4. Negotiate a lower purchase price

Essential Reading

NerdWallet’s September rate update calculates SBA 7(a) borrowing ceilings using a 7% prime rate. For loans above $350,000, the variable-rate cap is prime plus 3 percentage points, or 10%. The fixed-rate cap for loans above $250,000 is 12%. Smaller loans carry higher caps. A fixed-rate loan of $25,000 or less can reach 15%, while a variable-rate loan of $50,000 or less can reach 13.5%. The article also separates 7(a) rates from SBA 504 rates, which typically range from 5% to 7% and are tied to the 10-year Treasury note. It explains how rate ceilings are set and why fees can cause the annual percentage rate to exceed the stated interest rate.