An earnout is a type of performance-based consideration that is typically included in the purchase price of a business when it is sold. The earnout is a way for the buyer to share the risk of the acquisition with the seller by linking a portion of the purchase price to the future performance of the business.
There are several types of earnouts, each with their own unique characteristics.
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Revenue-based earnout: This type of earnout is based on the revenue generated by the business after the acquisition. The seller is typically entitled to receive a percentage of the revenue generated by the business during a specified period of time after the acquisition. For example, if a business is sold for $10 million with a revenue-based earnout of 20%, the seller would be entitled to receive 20% of the revenue generated by the business for the next three years.
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Earnings-based earnout: This type of earnout is based on the earnings of the business after the acquisition. The seller is typically entitled to receive a percentage of the earnings generated by the business during a specified period of time after the acquisition. For example, if a business is sold for $10 million with an earnings-based earnout of 20%, the seller would be entitled to receive 20% of the earnings generated by the business for the next three years.
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Milestone-based earnout: This type of earnout is based on the achievement of specific milestones, such as the launch of a new product or the attainment of a certain level of revenue. The seller is typically entitled to receive a payment when the milestones are achieved. For example, if a business is sold for $10 million with a milestone-based earnout, the seller would be entitled to receive a $500,000 payment if the business launches a new product within the next year.
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Combination-based earnout: This type of earnout is a combination of the above types. It can be based on revenue, earnings, and milestones. The seller is typically entitled to receive a payment when the milestones are achieved—a percentage of revenue or earnings generated by the business during a specified period of time after the acquisition.
An example of a revenue-based earnout would be a company that sells software as a service. The company is sold for $10 million, and the purchase agreement includes a revenue-based earnout of 20% for the next 3 years. This means that the seller will receive 20% of the revenue generated by the business for the next three years. If the business generates $2 million in revenue in the first year, the seller would receive $400,000 as part of the earnout.
An example of a milestone-based earnout would be a biotech company that has a promising new drug in development. The company was sold for $10 million, and the purchase agreement includes a milestone-based earnout. The seller will receive a $1 million payment if the drug is approved by the FDA within the next year and another $1 million payment if the drug reaches $50 million in sales within the next 3 years.
An example of a combination-based earnout would be a company that is sold for $10 million and the purchase agreement includes a combination of a revenue-based earnout of 20%, a milestone-based earnout of $500,000 when the business launches a new product within the next year, and an earnings-based earnout of 15% for the next three years.
In conclusion, earnouts are a type of performance-based consideration that is typically included in the purchase price of a business when it is sold.
