Earnout
What it is:
An earnout is an agreement between the buyer and seller of a business whereby the buyer agrees to pay the seller additional money based on the performance of the business.
How it works/Example:
Let's say Jane Smith buys a frame business from John Doe for $1 million. Jane is unsure about the neighborhood, and she only can get a loan for $700,000. She negotiates an earnout with John.
Under the agreement, Jane agrees to pay John 5% of gross sales for the next eight years. That way, if the business does more than $700,000 a year in gross sales, John will make at least $280,000 or more during that time (5% of $700,000 = $35,000 x 8 years). However, if the business does less than $700,000 a year, he will get less from the earnout.
Why it matters:
Earnouts can be structured in a variety of ways, but the general idea is to encourage the sellers of businesses to be truthful about their businesses' earnings potential with buyers. They also encourage them to stick around and provide guidance to the buyer after the sale. Earnouts also help buyers feel more secure about the possibility of overpaying for a business that doesn't perform as expected.