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Skip to Content. Skip to Main Menu. Confidential Advice Line: Buying or selling a business? Contact our team on As previously mentioned, during a negotiation, buyers and sellers will usually have differing views on valuation. This is no cause for concern so long as their views fall within the zone of possible agreement ZOPA. These circumstances typically fall into one or more of the following categories:.
One such example is sentimental attachment by sellers that drive up price, which most often occurs when founders choose to sell their companies i. Buyers also have their set of emotional drivers. One such common example is buyers who undervalue a target as a fear induced knee-jerk reaction to a past experience gone bad.
Based on my many past experiences, I have constructed a case study that will help simulate and explain how to structure an effective earnout. It is as follows:. Firm A buyer has conducted an internal strategic review and concluded that it suffers an important product gap.
Its competitive landscape has evolved such that its customers now prefer one-stop-shop solutions that include Product X, which it does not currently produce. NDAs and financial and operating data begin to be exchanged in a data room. Firm A explains that Firm B has only one year of financial history and that, though profitable, they are yet to prove that they can capture market share from other competitors.
Conversely, Firm B explains that Product X is powered by patented, proprietary technology lower cost and is sufficiently differentiated from other products in the market to not only capture share but create new demand.
After days of negotiations, both firms find themselves in a purchase price deadlock depart without an agreement. Given that Firm A understands the strategic value to acquiring the capability to manufacture Product X as soon as possible, it opts to design an earnout structure that bridge the valuation gap, driven by its future cash flow concerns and thus breaking the negotiation deadlock.
These elements are best explained and understood sequentially, with each element building on the next. Total purchase price or headline purchase price : The first step is to determine what the total amount is that will be received by the seller.
This signals to the seller that the buyer is willing to bridge the entire valuation gap and affords the seller the opportunity to earn the purchase price asked. Up-front payment: The second step is to determine what portion of the total purchase price will be paid at the transaction closing.
Often, buyers want to further derisk the transaction by lowering the up-front payment below their calculation of enterprise value, shrinking the risk zone. Contingent payment: The third step is to determine the contingent payment , where the contingent payment is defined as the total purchase price less the up-front payment.
Such metrics should be mutually agreed upon, well understood, clearly defined, and easily measured. There are two categories of performance metrics, financial and operational. Financial metrics are typically revenue or profits based, e.
Revenues is used when the target firm is fully integrated into the buyer, making it very difficult to measure the stand-alone profit profile post-assimilation.
And profit-based metrics such as EBITDA are used when the target firm will continue to be operated as a stand-alone subsidiary with its own set of discrete financials. Operational metrics are typically measured via milestones and are most common in technology companies or pharmaceutical firms where a new product development can greatly increase the EV of the target firm.
Parent shall not, and shall not authorize or permit its Affiliates to, i take any action with the intent of avoiding or reducing the payment of any Earnout Payment, ii divert to another business of Parent or its Affiliates any business opportunity in a manner that could reasonably be expected to or does diminish or minimize the Earnout Payments, iii take any action for the purpose of shifting Gross Revenues outside of the Earnout Period or iv reduce Gross Revenues including by providing discounts, rebates or other price concessions in a manner inconsistent with prudent industry practice.
Dispute Resolution. Late Payments. Any late payments on Earnout Payments owed shall accrue interest at the rate of 1. No Offset. Parent may not offset or withhold any amounts due hereunder for any reason. Acceleration of Maximum Earnout Payments. Material Inducement. Here is sample earnout section to an acquisition agreement, based on EBITDA milestones over three years, with language favorable to the buyer:.
Parent shall pay the Earnout Payment to the Company Stockholders, in annual installments in the amounts and upon the conditions as set forth herein below and in such amounts as is set forth in the [Merger Consideration Spreadsheet. Each Earnout Payment that is earned shall result in a payment in the aggregate to the Company Stockholders in such amounts as set forth on the Merger Consideration Spreadsheet. From the Effective Time through the end of the Earnout Period, Parent shall not take any willful action the sole purpose of which is to prevent or reduce generation of EBITDA sufficient to enable payment of the maximum Earnout Payment payable under this Agreement.
For purposes of this Agreement, the following terms have the following respective meanings:. Richard D. See all his articles and full bio on AllBusiness. This article was originally published on AllBusiness. This is a BETA experience. You may opt-out by clicking here.
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