Question

Will the value of earnout increase or decrease with the following and WHY?

ii. As volatility of operating income is increasing

Answer 1

An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings. 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 $1,000,000 plus 5% of gross sales over the next three years. Earnouts do not come with hard and fast rules; instead, the payout's level is dependent on a number of factors, including the size of the business. This can be used to bridge the gap between differing expectations from the buyers and sellers. The earnout helps eliminate uncertainty for the buyer as it is tied to future financial performance. The seller also receives the benefits of future growth for a period of time.

For Example:

ABC Company has $500 million in sales and $50 million in earnings. A potential buyer is willing to pay $250 million, but the current owner believes this undervalues the future growth prospects and asks for $500 million. To bridge the gap, the two parties can use an earnout. A compromise might be to an upfront cash payment of $250 million and an earnout of $250 million if sales and earnings reach $1 billion within a three-year window or $100 million if sales only reach $600 million.

Many earn-outs are structured on a measurement basis of gross margin, operating income or EBITDA. A substantially greater number of financial impacts and categories affect these measurements.

Hence, Value of Earnouts increase or decrease with the volatility of operating income is increasing.