Legal Definitions - earnout agreement

An earnout agreement is a contractual arrangement used in the sale of a business where the final purchase price is not fully determined at the time of the sale. Instead, the buyer pays an initial amount upfront, and the seller receives additional payments later, contingent upon the business achieving specific performance targets or financial milestones in the future.

This type of agreement is often used when there is uncertainty about the future value or performance of the business being sold, or when the seller's continued involvement is crucial to its success. It incentivizes the seller to help the business perform well after the sale, as their ultimate compensation depends on it.

• Example 1: Acquisition of a Software Startup

  A large technology company, "Global Innovations," decides to acquire a promising but relatively new software startup, "CodeCraft Inc.," which has developed a revolutionary new app. Global Innovations pays CodeCraft's founders $10 million upfront. However, the agreement includes an earnout clause stating that the founders will receive an additional $5 million if their app achieves 2 million active users within two years of the acquisition date, and another $3 million if it generates $10 million in subscription revenue within three years. The founders also agree to stay on as key executives within Global Innovations for at least four years to ensure the app's continued development and growth.

  This illustrates an earnout agreement because the initial payment is made, but a significant portion of the total purchase price is tied to the future performance of the acquired app (user growth and revenue generation). The founders' continued employment incentivizes them to meet these targets, directly impacting their final compensation.

• Example 2: Sale of a Boutique Marketing Agency

  Sarah, the owner of a highly successful boutique marketing agency, "Creative Edge," decides to sell her business to a larger advertising conglomerate, "Brand Builders." Brand Builders pays Sarah $1.5 million at closing. The earnout terms stipulate that Sarah will receive an additional 15% of all new client contracts secured by Creative Edge's existing team over the next three years, up to a maximum of $750,000. Sarah agrees to remain as the creative director for Brand Builders' new "Creative Edge" division for at least two years to ensure a smooth transition and maintain client relationships.

  This demonstrates an earnout agreement because the final sale price is not fixed. Sarah receives an initial payment, but her ability to earn more depends on the future success of the agency in securing new business. Her commitment to stay on helps ensure that the agency continues to perform well, directly influencing her earnout payments.

• Example 3: Retirement Sale of a Specialized Manufacturing Business

  Mr. Chen, the founder and sole owner of "Precision Parts Co.," a niche manufacturer of custom industrial components, decides to retire and sell his business to a younger entrepreneur, Lisa. Lisa pays Mr. Chen $2 million upfront. To ensure the business maintains its profitability and client base, the agreement includes an earnout: Mr. Chen will receive an additional payment equal to 5% of Precision Parts Co.'s net profits for the next five years, capped at $1 million. Mr. Chen also agrees to serve as a consultant for Lisa for one year, helping her understand the manufacturing processes, introduce her to key suppliers, and transition important client relationships.

  This is an earnout agreement because the total amount Mr. Chen receives is not fully known at the time of sale. While he gets an initial sum, a portion of his compensation is contingent on the future profitability of the business. His consulting role helps ensure the business continues to generate profits, thereby increasing his potential earnout.