What is an earnout and when is it appropriate?
by Dominic Watson
An "earnout" agreement is the sale of a business involving part of the sale price being determined by the performance of the business over an agreed post-sale trading period.
A sale involving an earnout will typically involve an initial payment on completion of the deal, followed by further deferred payments over a number of years.
The earn out payments are normally calculated and paid as a percentage of annual turnover or profits.
A typical earn out deal for an optical practice might look something like this:
- The purchaser pays £150,000 on the date of completion
- The purchaser pays a second sum based on 10% of annual sales in their first 12 months of ownership
- The purchaser to pay a third sum based on 10% of annual sales in the 2nd year of trading
Turnover is the most common measure of performance, due to the simplicity of measurement. Measuring profits can be significantly more complex and expensive to encapsulate within a contract and to police in practice. Without relevant protection, profit can be suppressed or manipulated by the buyer to reduce the amount they pay.
Legal and professional bills for earn outs based on profits tend to be significantly higher for both buyer and seller. The parties have to agree on a detailed, prescriptive framework of how during the earnout period the accounts must be structured in terms of what constitutes a fair expense or drawing. Whilst much rarer, there are specific circumstances where it is appropriate for an earn out to be based on profits but this is unusual in the optical sector and is beyond the scope of this brief overview.
In summary, the key variables are:
- The sum paid on the date of completion
- The measure against which the earn out is to be measured (i.e. annual turnover or profit)
- The percentage of annual turnover or profits the extra payment will be made against
- The threshold (if any) over which the percentage will be paid
- The number of years the earn out will run for (typically between 1
How common are earn outs in the optical market?
Normally sales involving an earnout arrangement are the exception rather than the rule in the optical market.
Why use an earnout?
Most practice sales are conducted on the basis of a fixed agreed fee, based on historic performance. An earnout is most likely in the following circumstances:
- A major part of the revenue of the business is dependent upon one or two major corporate clients (typically this will relate to domiciliary or RX houses rather than high street practice)
- Concern from the buyer that the departure of a key member of staff (e.g. the director) may have a detrimental effect on future trading performance. An earnout is used as a way of hedging against a downturn in the business if the key member of staff departs
- Recent / impending change to the historical trading conditions against which the business has produced its sales and profits against which the business has been valued. For example a new competitor may have just opened up, or is about to open up locally which may have an adverse impact on the trading performance
- Declining sales - for example a scenario where the owner is citing that reduced sales are due to them being unwell, absent from the business due to family/personal reasons or distracted by other business interests. The purchaser is buying the business on the premise that there is nothing structurally wrong with the business; that the vendor has just not been in a position to test / recall / market the business in the normal way that produced the historical profits. The purchaser again will try to negotiate the earnout to ensure that they pair a fair price based on the post-sale performance
- A very high price / premium is being paid on the business based on a pattern of growth and where the valuation is based on projected growth in profits. The earn out protects the purchaser and makes sure that they only pay for real tangible profits rather than potential profits that fail to materialise