As a founder looking to exit your startup, you will inevitably see earnouts as part of the structured offers you receive.
Earnouts are very common when it comes to structuring a SaaS M&A deal. Knowing how to structure a deal effectively is the best way for you to optimize your exit and proceeds from the sale.
So let’s get inside the buyer’s head, break down what earnouts are, and learn how they improve your upcoming deal structure.
What Is an Earnout?
In an M&A deal like those Acquire.com facilitates daily, it’s common for the seller to receive only a partial amount of cash on the day the transaction closes, and additional compensation payment in the future.
That additional compensation can take different forms:
- A seller note: where you provide the financing of part of the purchase price to the buyer and accrue financial interest until the buyer repays the outstanding amount.
- Retention amounts: where a third party holds part of the purchase price to guarantee the cash is there to cover a potential warranty claim.
- An earnout: which is additional compensation based on the future performance of the company, post-transaction.
Why Use an Earnout?
The concept of an earnout is simple: instead of paying you the full price for your startup upfront, the buyer pays a lump sum and then the remainder upon your startup meeting certain targets. However, buyers use earnouts for different reasons so it’s key to understand the buyer’s or investor’s motivations. This will also help you design a better deal structure and counter-offer effectively in the negotiating process.
A Gap in Price Expectation Between You and the buyer
This happens all the time. You, as a seller, are expecting a higher price than the buyer is comfortable paying. In this scenario, if the discrepancy between the bid and ask is not an unbridgeable gap, an earnout could be the solution.
For example, let’s assume the buyer of your SaaS company is willing to pay up to 6x Seller Discretionary Earnings (SDE), but you’re unwilling to sell for less than 7x SDE.
If the buyer wants to close the deal, they can agree to a 7x SDE valuation but only if the company achieves certain milestones post-acquisition, like a 30% ARR growth next year.
Then, depending on the situation, the buyer can either agree to your offer of 6x SDE upfront + 1x SDE earnout, or the buyer might ask you to meet them halfway and agree on a 5x SDE upfront + 2x SDE earnout, for instance.
From the buyer’s perspective, this is the same as telling you, “If your business indeed delivers on the 30% ARR growth you promised, I am happy to pay the 7x SDE multiple you were asking for.”
Remember that the value of a company is based on its future expected cash flow, not its past.
An earnout structure is even more suitable when there was either a recent strategic shift, pricing change, or product launch.
Naturally, if you’ve made these changes it is because you believe it will benefit the company long term. From the buyer’s perspective, however, a recent change represents more uncertainty hence more risk.
Earnouts help you justify a higher valuation since you effectively underwrite some of the buyer’s risk.
Earnouts Give Buyers Confidence to Offer Your Ideal Price
When a buyer purchases a company, due diligence helps reduce risk but can’t eliminate it.
For instance, your company may have a few important clients, maybe even relatives. These customers may cancel their contracts with the buyer if you leave and the buyer appoints a new CEO.
Buyers might not be as familiar with your market either, and fear changes that impact the company top-line going forward (a new federal bill in the making, a change of strategy of one of your main enterprise customers, and so on).
Such unexpected events are outside of your and the buyer’s control, but the buyer might expect you to share that systemic risk. A natural disaster, for example.
In such scenarios, the buyer seeks protection against downside risk rather than a “guarantee” the business will perform well in the future.
For example, you could define an earnout as 70% of the total purchase price paid upfront, 15% paid after one year, and 15% after two years under the condition that the ARR does not fall below its current level.
I recently structured a deal where we’d take over management of the company. The seller was reluctant to tie the earnout to performance since it would be outside of his control.
We took the current ARR and the historical average churn and then listed all the seller’s current clients. We then agreed to pay the full earnout as long as the existing clients were still generating at least [(1-churn rate) * current ARR] in revenue.
That was our way of saying, “We’re happy to pay the full price as long as your current customers do not churn faster once we take over.”
Protecting the buyer’s downside might be even more important than delivering outstanding growth, especially when they’re leveraging the deal with debt.
So being very transparent, building trust with your potential buyers, and having clean reporting will greatly help you in your negotiation.
Earnouts Give Protection Against Defaulting on a Buyer’s Loan
Some buyers (a lot more in the US thanks to SBA loans) use debt to Acquire a microSaaS company.
If the amount of debt used to finance the deal is, say, 60 percent to 80 percent of the purchase price, the buyer must service the loan from the cash flow generated by the business to avoid defaulting (and risking legal pursuit or seizure of personal assets).
In this scenario, the buyer assumes the amount of leverage on the expected future cash flow of the business. If the business underperforms, the risk for the buyer is quite significant.
An earnout might then be necessary for the buyer.
In a recent deal, for example, we used leverage to meet the seller’s asking price. To service both the loan and the earnout, we needed the business to generate a minimum of $3 million per year for the first two years.
The business was generating $4 million at the time, but it was obvious that cash flow had doubled due to COVID and we suspected it could soon revert to $2 million per year. However, the owner was still pushing to value the company on a $3 million cash flow.
We then made the earnout conditional on us meeting our debt obligations, which we’d only pay the earnout if the business generated at least $3 million per year going forward.
If you’re in such a scenario, here are some alternative ways you can address the above, or negotiate:
- Agree to the aforementioned earnout structure under the condition that if the business generates above $3 million cash, the buyer pays your earnout faster. (For example, for an earnout of $2 million paid over two years, you could argue that if in its first year the business generates $3.5 million, you get $1.5million out of the $2 million.)
- If the problem is only due to the capacity of the company to service the debt, instead of an earnout you can offer a seller note and agree to postpone repayment if the buyer is tight on cash. A seller note is a debt instrument and has to be repaid regardless of the performance of the business which gives you greater certainty of being paid the full purchase price.
Incentivizing You to Deliver Outstanding Performance
This logic applies in the scenario where you remain operationally involved in the business, post-acquisition.
Typically, when you exit a business worth a few million dollars, you might not be as motivated to continue growing the business as you were when you owned the company.
The new owner could use an earnout to keep you motivated. It’s also another way of saying: “If you deliver outstanding performance under my ownership, you’ll get your extra share of the pie.”
History tells us it does not always work out as planned (like Whatsapp’s founders casually walking away from $850 million), but overall, in the world of SaaS, this is a great way to keep you excited and can be very rewarding, financially.
How to Structure an Earnout
Let’s break down earnout into its main components.
Cash Upfront
How much does the buyer pay in cash upfront and how much is deferred?
Every situation is different but the “rule of thumb” is that the bigger the gap between the bid and ask, the less cash upfront the buyer will be willing to pay.
It’s all about risk and reward.
Buyers are happy to pay more to protect themselves from the uncertainty of the future. You, on the other end, can agree to take more risk for a greater pay-out.
The split between cash upfront and earnout varies. A 20 percent to 30 percent earnout is quite common, but I’ve also seen deals close on 90 percent to 100 percent earnout.
The latter would usually make sense in the case of a distressed company that a buyer can turn around, or from a strategic buyer who can bring a lot of synergies to the table, like a wide base of customers or distributors.
KPIs
Which metrics is the earnout based on?
This, in my opinion, is the trickiest part of structuring an earnout. It’s like designing a management incentive scheme: you know there are plenty of ways to manipulate the numbers or shift attention to specific metrics.
Spoiler alert, there is no right answer here. It’s going to rely a lot on the relationship and trust between you and the buyer.
The most common metrics used are generally financials, like Revenue or EBITDA, or operational metrics (number of new customers, website traffic, average revenue per user, and so on).
A simple example:
The buyer is a financial investor and the seller will remain in charge of operations.
If the earnout is based on revenue, it incentivizes the seller to to drive revenue up, which can often lead to lower margin (eg. through discounts, special offers or more aggressive marketing).
If the earnout is based on EBITDA, it incentivizes the seller to closely monitor costs towards the end of the year to hit the target, which may not be the best decision for the long-term development of the company.
A better structure, in this case, would be to agree on a combined target of revenue growth + minimum EBITDA margin.
In the case where you, the seller, are not involved post-transaction, defining KPIs becomes trickier since the buyer will have full control over the operations.
I generally advise against a pure EBITDA-based earnout. Without any malicious intent, EBITDA may not hit the earnout target due to pure strategic decisions (if the new owner decides to increase marketing spend to drive growth, for instance).
When it comes to SaaS and recurring revenue businesses, a growing ARR is in the best interest of the new owner. Therefore, if you’re not involved in the operation post-transaction, I’d structure the earnout around ARR. This is also easier to monitor and check than other metrics like EBITDA whose definition can lead to harsh conversations.
You and the buyer should think carefully about the KPIs and their impact on the business and state clearly in the contract how those KPIs are defined and calculated.
When the buyer is a strategic buyer and intends to merge your company into their own, the design of an earnout becomes even trickier.
Timeline
What period is the earnout going to be spread over?
General market practice for earnouts in M&A is a horizon between one and five years. From my own experience, in the microSaaS space, a one-to-three-year timeline is more typical.
If you’re not involved operationally post-acquisition, a one-year earnout is generally negotiable without too much friction, but negotiating over two years, understandably, becomes quite complicated.
Payment and Missed KPIs
When is the earnout paid and how are partial payments calculated?
Let’s take the example of a $3 million earnout paid over three years under the condition that the business keeps an ARR of at least $5 million each year.
From there, you can be as creative as you want to structure the payout. Let’s first look at three different scenarios in which your startup meets the target ARR each year.
- Each year you receive $1 million.
- After three years, you receive $3 million.
- You design a progressive payout, such as 20 percent in the first year, 30 percent in the second, and 50 percent in the third.
Now, let’s cover the case where your startup DOESN’T meet the $5 million ARR target.
It is very rare to have an all-or-nothing structure where you get nothing if your startup doesn’t meet its target.
However, designing a linear payout where if the company hits $2.5 million ARR instead of $5 million, the seller gets 50 percent, is not sensible either.
Floor and Ceiling KPIs
To design a fairer structure while avoiding over-complexity, I’d recommend you design a floor and ceiling KPI.
In our example, the ceiling is $5 million ARR. You could set the floor at $4.5 million ARR. And if ARR falls within the floor and ceiling, you get a proportionate amount of the earnout, with floor corresponding to 0 percent of the earnout and ceiling to 100 percent.
In other words, if ARR at the end of the year is $4.75 million, you’d receive 50 percent of the earnout for that year.
Catch-up Provision
If you don’t meet the earnout KPI in one year, is there a “catch-up” provision?
For example, assuming you’re eligible for $1 million per year, if the ARR is $4.5 million in the first year (corresponding to 0% of the first year earnout getting paid) but hits $6 million in the second year, you can try and negotiate to receive $2 million at the end of the second year.
When Is the Earnout Paid?
The time at which you earn the earnout and when it’s paid is also a negotiation point.
For instance, you might hit the earnout target for the $1 million earnout, but get paid six months later. In other words, that’s a way to offer a 0% interest credit line to the buyer which gives them six additional months of cash flow from the business to pay the earnout.
Other Risks and Factors to Consider
When you structure a deferred payout, ensure you include a clause in the purchase agreement that deals with exceptional situations.
For instance, discuss what should happen if the buyer decides to sell the company before the earnout period expires, divest part of the business, or to discontinue one of the products.
You can also include a clause stating that if the new owner drives the business into the ground, you have the right to regain control of operations at least until the earnout period is over.
Add a clause granting access to certain information to ensure you’re paid what you’re owed. You could contractually agree to have full access to accounting or bank statements upon demand, for instance.
Generally speaking, it’s always best practice in these negotiations to be assisted by a good SaaS M&A advisor and a good lawyer.
Earnouts can be a super powerful and creative strategy when it comes to selling and negotiating the acquisition of your startup. You can use all the above to help you better respond to the LOI you receive.
If you understand earnouts well, they can be a great tool for any SaaS owner to control the conversation, potentially increase your payout, and reach a mutually satisfying agreement.
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