Earnout Term Sheet Template.
Earnout refers to a deal structure in mergers and acquisitions, to buy or sell a business, where the seller must “earn” part of the total purchase price based on the performance of the business following the signed definitive or purchase and sale agreement.
Earnouts are usually used when the buyer and seller have different views about the expected growth and future performance of the target company. A typical earnout takes place over a three to five-year period after closing of the acquisition and may involve anywhere from ten to fifty percent of the purchase price being deferred over that period. Earnouts are popular among private equity investors, who do not necessarily have the expertise to run a target business after closing, as a way of keeping the previous owners involved following the acquisition.
The financial targets used in an earnout calculation may include revenue, net income, EBITDA or EBIT goals, and the selection of metrics also influences the terms and conditions of the earnout. Sellers tend to prefer revenue as the simplest measurement, but revenue can be boosted through business activities that hurt the bottom line of the company. While buyers tend to prefer net income as the most accurate reflection of overall economic performance, this number can be manipulated downward through extensive capital expenditures and other front-loaded business expenses. Some earnouts may be based on entirely non-financial targets such as the development of a product or the execution of a contract.
The terms and conditions of an earnout are largely dependent on which party will actually manage the business following the closing. If the buyer will manage the business, the seller may be concerned with mismanagement by the buyer which causes the company to miss targets. On the other hand, if the seller will manage the business, the buyer may be concerned with the seller either minimizing or understating expenses or overstating revenue so as to manipulate the earnout calculation.