Preparing for Earnouts in Lower Middle Market (LMM) Business Sales
You may have heard of an “earnout” in business sales, but you may not have been sure exactly what it is or when it is used. An earnout is a payment structure in a business sale that links the purchase price to the business's future performance. It’s typically used when the buyer and seller have different valuation expectations or uncertainty regarding the company’s future earnings.
Earnouts can be practical tools in lower middle market (LMM) deals ($5M-$25M.) The key is carefully negotiating the terms and making sure both parties have a clear understanding of them. Earnouts can benefit both buyers and sellers. Earnouts help buyers reduce the risk of overpaying for a business with a possibly uncertain future. They can also incentivize the seller to stay involved in the industry to help it succeed post-sale. Sellers can achieve a higher sale price by bridging any valuation gaps. Since earnouts can be tailored with specific financial or operational goals, such as revenue milestones, profitability targets, or customer acquisition metrics, this lets sellers retain some control over how they’ll be rewarded based on various outcomes.
Understanding Earnout Structures in Mid-Market Deals
A fixed payment is a financial agreement that provides a predetermined amount without conditions. Earnouts are contingent payments that depend on future conditions, such as performance or events. They are only made if the specific terms have been met.
The basic structure looks something like this…
Initial Payment: The buyer pays part of the purchase price upfront. The remaining amount (the earnout) is contingent on the business achieving predetermined specific performance targets over a defined period, usually 1–3 years.
Payout of Earnout: If the business meets the performance targets, the seller receives additional payments based on the agreed terms. If the company does not meet the goals outlined in the contract, the seller may receive a reduced payment or nothing at all for that particular portion of the sale.
Key Terms and Financial Metrics Linked to Earnouts
Deferred Payments: payments that are only made if specific criteria have been met (financial target, strategic goal, or other predetermined metrics)
Revenue Targets: a desired amount of income the business aims to earn over a specific period of time
EBITDA-Based Earnouts: EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. In this type of financial agreement, the seller receives additional compensation based on the company's future performance after the sale.
Net Income: goals based on the total value of sales minus any expenses, taxes, and interest
Customer Retention: goals based on how long or how many current customers remain with the business post-sale
Customer Acquisition: goals based on the number of new customers that are brought in post-sale
Product Launches: can be used for an earnout once the criteria for a “successful” product launch are determined
Geographical Expansion: earnout based on the number of new locations a business successfully opens post-sale.
Negotiating an Earnout: Best Practices for Sellers
A seller needs to set realistic goals when negotiating an earnout. The targets should be based on historical performance and industry trends. The seller should also build safeguards into the contract that address and define issues such as allowable expenses, post-sale changes in management, or M&A activity that could impact performance. Essential aspects of earnouts include timing and payment terms. Payouts should be structured to support liquidity and stability for both parties.
Maximizing Post-Sale Earnings Through Earnout
A successful business sale with structured earnouts will maximize earnings. This can be done by establishing clear, regular updates and transparent reporting processes. These will allow for any course corrections or adjustments that should be made to achieve maximum earnings. Establishing mutual goals of the buyer and seller can also prevent possible friction and support a smoother process.
Common Challenges and How to Overcome Them
To avoid disagreements about metrics and whether goals have been met, define the metrics precisely and use third-party auditing if needed. Establish clear contract terms that cover every scenario, including dispute resolution. The buyer might instill changes to the business that unintentionally negatively impact performance. Mitigating any management, investment, or business strategy risks is essential. Finally, while not in your control, do your best to prepare for the possibility of external changes, such as market trends and economic shifts, affecting earnout targets.
Preparing for Earnouts as Part of a Comprehensive Exit Strategy
Earnouts are valuable tools in lower middle-market business sales. When negotiated to benefit the buyer and seller, they can optimize the overall sale value.
Mark Hartmann is a three-time Inc 500|5000 CEO with a rich sales, operations, and leadership background in the insurance, financial services, and healthcare sectors. With extensive experience growing and selling his own businesses, Mark leverages his expertise to help owners grow and sell businesses valued at $1M —$25M. He’s earned a Master of Business Administration from Eastern University, a master of science degree in organizational change management from St. Elizabeth University, and a graduate certificate in executive coaching from Columbia University. Mark’s professional certifications include Certified Mergers and Acquisitions Professional (CM&AP), Certified Business Intermediary (CBI), Certified Exit Planning Advisor (CEPA), and Certified Value Builder (CVB).