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How to SMS Earn Out Agreement

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Mergers and acquisitions often report fixed prices, like Company A acquiring Company B for ten million dollars. However, this price can include contingent payouts, known as earn-outs. An earn-out allows the seller, typically shareholders of the target company (Company B), to receive additional funds if specific financial goals are met over the next few years. For instance, the acquiring company (A) might agree to pay ten million upfront and an extra five hundred thousand if Company B achieves at least two million in net income within a year. This means the total payment could exceed the initial ten million, depending on Company B’s performance.

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What is an earn-out in a purchase agreement?

Often, when buyers and sellers want to complete a deal but cant agree on the price, they employ a strategy called an earn-out. An earn-out is a contingent payment that the seller only receives from the buyer when specific performance targets are met.

What is a typical earn out percentage?

The typical term of an earnout is one to three years at approximately 10% to 25% of the purchase price. Earnouts are popular with private equity groups that do not always have the expertise to run a business and want to keep the owner incentivized following the closing.

How is fair value calculated for Earnouts?

Simply stated, earnout value is equal to the probability of success, or of each possible outcome, multiplied by the amount to be paid given the outcome. Usually, the company assesses the probabilities and then applies a discount based on the time value of money and the probability that the company is unable to pay.

What are the different types of earnout structures?

Typically, the two types of earnout compensation are a right to fixed payments (guaranteed) and contingent payments (subject to achieving financial milestones).

What is an example of an earnout agreement?

For example, if the seller thinks the business is worth $100 million and the acquirer believes it is worth $70 million, they can agree on an initial price of $70 million and the remaining $30 million can form part of the earnout.

How does an earn-out clause work?

In a standard earnout arrangement, the buyer agrees to pay the seller additional amounts if certain performance thresholds are met within a particular time. The seller holds the earnout right.

How do you structure an earnout agreement?

Earnout structures involve seven key elements: (1) the total/headline purchase price, (2) the % of total purchase price paid up front, (3) the contingent payment, (4) the earnout period, (5) the performance metrics, targets, and thresholds, (6) the measurement and payment methodology, and (7) the target/threshold and

What is an example of an earnout clause?

If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1 million plus 5% of gross sales over the next three years.

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SMS Earn Out Agreement