Navigating the Earnout: What Sellers Need to Know for a Successful Business Exit

When selling a business, coming to an agreement on the fair value for the sale is just the start – there’s so much more the buyer and seller need to weigh in their negotiations!

The truth is that buyers and sellers often have different interests and risks to manage when negotiating the structure of a deal. A seller might want an all-cash deal, but since cash is significantly riskier for the buyer, buyers rarely want the same.

Instead, agreeing on an earnout structure can be a strategic move for everyone involved and a way to meet in the middle. While they require careful planning and thoughtful negotiation, an earnout structure can mitigate the buyer’s risk while serving as an offboarding ramp to the seller as they move into the next stage of their life.

Not sure if an earnout structure is the right move when selling your business? Let’s dive into the details to consider before you lock in any decisions.

What is an Earnout?

When selling a business, an earnout is one potential arrangement to compensate you for the sale. Under an earnout structure, the seller will profit if the business succeeds under new ownership and achieves certain goals over an agreed-upon time. All of these details should be clearly spelled out in your deal.

Not all sales are conducive to an earnout payment, but there are a couple of markers that can determine whether this method will be useful.

First, earnouts often take place when a seller’s asking price is more than a buyer is willing to pay outright in cash. In this way, earnouts can essentially spread the purchase over a longer period, aligning the expectations of both buyer and seller. This method allows the seller to continue earning with the success of the business under new ownership. New owners may bring with them management teams and strategic ideas that can propel the business forward in partnership with the seller.

Another situation where earnouts are often used is when the performance of the business depends on key employees and executives remaining with the company for a period of time post-sale. A buyer may not want to pay top dollar in cash just to have key employees depart shortly after, causing financial performance to decline post-sale.

Common Structures and Terms of Earnout Agreements

With these scenarios in mind, let’s unpack some common deal structures and terms that can make an earnout agreement successful. When leveraging an earnout structure, what can you expect right away as well as down the road?

At the outset, some cash is paid to the seller upfront with the remainder to come from the earnout payments. The length of the contract and the seller’s role in the business post-sale will all be negotiated as part of the earnout agreement. This contract should be very thorough so everyone knows exactly what to expect over the months or years ahead.

Finally, there will likely be financial metrics for the earnout spelled out in the contract. These can include revenue growth, profitability, earnings targets, and other metrics.

It’s also crucial to include language about what the earnout means for the seller: Is the earnout structure part of the purchase price or is it compensation to the seller for services rendered?

If it’s part of the purchase price, the seller will be taxed at a capital gains rate. On the other hand, if it’s compensation, it will be taxed as ordinary income for the seller (likely at a higher rate than the capital gains tax rate).

Personal Wealth Planning Considerations

Planning for the possibility of an earnout should come well before a deal is made. The earnout structure can significantly impact the future you had in mind, from your immediate personal wealth post-exit to how you plan to spend your time.

Here are three factors to keep in mind before selling:

Cash Flow and Scenario Planning

Cash flow and scenario planning should be done before you negotiate a deal – ideally before an exit even becomes a reality. As the seller, you should have a clear understanding of what the money is for and your future liabilities based on those goals. To this end, detailed cash flow planning and projections are crucial for understanding what a seller needs from their exit to live the life they envision post-sale.

Pay special attention to short-term versus long-term goals and the cash needs for each. From our experience, many founders might need more cash in the early years post-exit. This is an exciting time and you may want to take advantage of your new freedom. Many founders want to travel with loved ones, buy vacation homes, invest in other ventures, or even explore philanthropic endeavors.

If an earnout structure is a possibility, you should understand how much cash you need to fund your dreams and goals. This is especially true because earnouts are not guaranteed and pose a risk for the seller. On the other hand, if the business thrives, the earnout structure may provide even more funds for your goals compared to an all-cash offer. A thorough plan will account for both best-case and worst-case scenarios, along with various points in between.

Ask yourself: Could an all-cash deal at a lower sale price still meet your needs? You will only know if you take the time for cash flow planning.

Set Yourself Up for Success Along the Way

Be careful to avoid viewing your business as the goose that laid the golden egg. What you think your business is worth and what a seller is willing to pay might be two very different things. Instead, prioritize ways to diversify your assets as a business owner.

In a perfect world, you’ll have years of time to plan an exit, maximize the business’s value, and scout out the ideal buyer. But life – and the timing of your exit – does not always go to plan. Shifts in the market, life events such as death or divorce, and more can force an early exit. When your exit is not fully on your terms, you may be forced to sell at a value that can’t quite meet the goals you had in mind.

This wealth gap between your business and personal finances is one of the most common reasons why a business exit can fail to meet your expectations.

To mitigate this risk, be sure to diversify outside your business. Leverage retirement plan contributions and invest in liquid assets that can grow your wealth and provide future income so you’re not entirely dependent on the business for your financial well-being.

Spend Time Building the Right Team

When it comes to building the right team for a successful exit, many founders make the mistake of waiting until their exit is imminent and a deal with an earn-out is on the table. After all, you may not plan to retire for ten, twenty, or even thirty years – why start now?

But like we just mentioned, the timing of your exit may not always be up to you. Planning well in advance of an exit can manage your risk in the event of an unexpected exit.

Moreover, building strong partnerships with a CPA or tax adviser, a wealth advisor, a trust and estate attorney, and even a business advisor can help your business and personal net worth grow and thrive in the here and now.

Start assembling key players well before you plan to make your exit. This enables you to lay a solid foundation for success and make optimizations as needed along the way, maximizing the value of your business and your personal wealth outside of the business.