When the seller of a business and the buyer do not agree on the sale price of the business, but are still keen to close the deal, they sign an earn out agreement, often abbreviated to earnout. In the agreement, the actual purchase price of business is dependent on the future profits that it earns. Usually, the seller gets involved in the business for the period mentioned in the agreement.
When Do You Need Earn out Agreement?
This agreement is required when both the buyer and seller are keen to consummate the deal, but are looking at a mutually agreeable way to bridge the gap between the seller’s expectations and valuation of the business and that of the buyer.
Here are some instances when you may require this agreement template:
- A startup with limited operating history
- A company with a new but unproven product or technology
- The buyer thinks that the company has been overvalued
- Incentivize the seller to stay involved in the business
- The seller wants to acquire the business, but cannot to pay the asking price
Purpose of Earn Out Agreement
The purpose of this agreement is function as an acquisition currency while incentivizing the seller to be part of the business operations. The idea is to ensure that the seller also works hard to help reach the performance target, so that they get paid the agreed amount while helping the buyer save money when buying the business.
Inclusions in Earn out Agreement
Some of the inclusions in the agreement include:
- Names and addresses of the buyer and seller
- Gross revenue
- Gross profit margin
- Adjusted EBITDA
- Employee retention rate
- Gross revenue per employee (full-time)
- Performance target
- Gross revenue growth rate
- Date of agreement commencement
- Date of agreement termination
- Amount paid to the seller
- Responsibilities and obligations of the seller
- Responsibilities and obligations of the buyer
How to Draft Earn out Agreement
When drafting an earn out agreement, it is best to keep the conditions simple, so that the buyer and seller hold up their end of the bargain. Besides the boilerplate clauses, the agreement should clearly state the following:
- Metrics to measure the future performance
- Establish tiers so that the seller gets some benefit for being involved with the business even if it misses its target performance
- Mention the valuation of the company
- The upfront amount paid to the seller
- The roles and responsibilities of the seller and buyer
- The payout period
- Terms and conditions to realize the deal
- What happens when either party breaches the agreement
It is best to consult a legal expert to help draft the agreement.
Pros and Cons of Earn out Agreement
Some of the advantages of earn out agreement are:
- Seller gets upfront payment with possibility of future payment on the business achieving performance targets
- Reduces the upfront cost for the buyer
- Provides a win-win solution to buyer and seller
- Seller stay involved until the end of the agreement period
- Reduces risks for the buyer
- Ensure transition in ownership is successful
Few of the disadvantages of earn out agreement are as follows:
- Seller cannot control the company any longer
- For the agreement to be successful, the business must be run the same way as before
- Non-compete clause may prevent seller to start or join a similar business
- Performance targets may be unrealistic
Types of Earn out Agreement
The different types of agreement are based on the kind of earn out payment that the seller will receive at the end of the agreement period. Some of the payments include:
- Cash payment, which can be a percentage based on predetermined measurement standards, like revenue, gross profit or net income
- Stocks or shares of the company once the business achieves the pre-defined performance targets
Key Terms/Clauses in Earn out Agreement
Some of the key terms of earn out agreement are as follows:
- Upfront Payment: Amount that the seller receives from the buyer after signing the agreement as part payment for acquiring the business
- Earn Out Payment: The amount that the buyer pays the seller based on the agreed percentage at the time of signing the agreement. Once this payment is done, the buyer does not owe the seller anything
- Performance Benchmarks: The metric that measures the performance of the business during the agreement period
- Earn Out Period: The period that the agreement will be valid. Usually, it is anywhere from three to five years
What Happens in Case of Violation?
If either party breaches the earn out agreement, the other party can resort to the remedies mentioned in the agreement. However, if the buyer and seller cannot resolve the issue amicably, it could result in an expensive lawsuit.
Sample Earn Out Agreement
A sample of the agreement can be downloaded from below.