How Common Are Earnouts?

How often are earnouts used? Small businesses generally don’t use earnouts and for good reason. In small business transactions there are typically short transition periods (usually sellers “earn” an earnout by staying during a transition), financials are often fairly messy so measuring earnout milestones are problematic, and buyers usually want to come in and operate the business as theirs without any of the operating limitations that often occur with an earnout arrangement. They occur with small businesses, but it is not common.

However, they are fairly common for larger companies in the lower middle market and middle market. Valuation gaps between buyers and sellers are common, and that naturally leads to discussions on earnout.

It is also fairly common for earnouts to disappear later in negotiations when the challenges of actually structuring the earnout become apparent. For example, how to measure the earnout, how long to make the earnout period and what operational limitations will be placed on the buyer are all typical issues to be worked out with earnouts (my next blog post will look at these in more detail.)

For example, last year I did a deal in which there was initially an earnout. During last minute negotiations with the two buyers still left bidding, one of the buyers dropped the earnout and made that payment a non-contingent note. That swung the deal his way and the next day the seller signed that buyer’s LOI. It also simplified the purchase agreement that would soon come.

The American Bar Association puts out a deal points study in which they organize deal information from a number of middle market deals. In 2007, they analyzed 103 deals and 20% of those deals had earnouts structured into the agreements. In 2009, 104 deals were analyzed and 29% had earnouts, which makes sense given the higher volatility and risk of earnings in 2009. Those deals were squarely in the middle market between $20 million and $100 million. For lower middle market deals at $20 million and below I think there are around 50% of deals that have earnouts.